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Yield-Focused Portfolios: Efficiently Generating Income and Returns

Income-oriented investing has become increasingly popular, but it’s been a difficult environment for such strategies since the Global Financial Crisis because of historically low interest rates. The post-crisis equity bull market has helped many investors tolerate the scarcity of yield, but the coming years may not be so kind. Even as monetary policy is gradually normalized, interest rates may not return to pre-crisis levels. In addition, we anticipate that most asset classes won’t be able to maintain the pace of their post-crisis rally. This leaves income-seeking investors with a dilemma: they can either accept low yields, take on more risk in the portfolio in order to achieve higher income, or eat into principal as a source of income.

To help address this challenge, we investigated how to design optimal yield-focused portfolios by taking a holistic approach to multi-asset portfolio con-struction that optimizes for a balance of yield, return, and risk attributes. Our goal was for these portfolios to offer higher income without sacrificing long-term total returns or “efficiency” (risk-adjusted return, or return per unit of volatility). We believe that such portfolios will be more resilient to challenging market environments – such as a rise in interest rates, or credit-related market stress – than less-diversified approaches that focus exclusively on maximizing current yield by simply adding high-yield assets to an existing portfolio.

Contents

3 Constructing Efficient Yield-Focused Portfolios

5 The Yield-Focused Portfolios

9 Diversification and Risk Sensitivities

11 Performance Risks

14 Final Thoughts

CIO Americas, Wealth Management 21 March 2018

This report has been prepared by UBS Financial Services Inc. (“UBS FS”).

Please see important disclaimer and disclosures at the end of the document.

Authored by:Jason Draho, Ph.D., Head of Tactical Asset Allocation Americas Leslie Falconio, Senior Fixed Income Strategist Americas Ronald Sutedja, Quantitative Strategist AmericasJustin Waring, Investment Strategist Americas

2 of 19 March 2018


This research led the UBS Wealth Management US Asset Allocation Committee (AAC) to develop a new suite of yield-focused Strategic Asset Allocations (SAAs). These new yield-focused portfolios are complementary to the existing UBS House View portfolios, as they differ in their total return compositions and risk attributes. Based on the UBS Capital Market Assumptions (CMAs) they have similar estimated total returns, but income is a larger component of the esti-mated return for the yield-focused portfolios (our estimates suggest at least 50% more). Historical performance simula-tions derived under the assumptions detailed on page 11 produced similar total return profiles for both portfolios, and we expect their long-run total returns to be similar in the future.

Both our CMAs and historical simulations suggest that the yield-focused portfolios should have similar total risk as the House View portfolios. But they also have distinct risk prop-erties, including the potential for greater drawdowns and negatively skewed returns, larger concentrations in asset-specific risks, and greater exposure to liquidity gaps in some asset classes, which are all detailed in the performance risks section of the paper.

Consequently, while these portfolios have many appeal-ing properties, they’re not appropriate for all yield-seeking investors. In particular, these portfolios are not designed to preserve capital above all else, as one of our goals for them is capital appreciation. Altogether, we think that these yield-focused portfolios offer a holistic solution that improves upon more conventional approaches to income investing. They also complement the House View portfolios because they’re designed to meet different investor objectives, with different return and risk trade-offs. The rest of the paper explains how the yield-focused portfolios were constructed, their properties, and how they compare to the House View portfolios.

https://www.ubs.com/content/dam/WealthManagementAmericas/documents/yield-focused-strategic.pdf

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The development of the yield-focused portfolios relied on two fundamental elements of finance theory: mean-variance optimization – used to derive an efficient frontier of portfo-lios – and risk factor analysis. The former is a foundational part of Modern Portfolio Theory dating back to the 1950s, and is used by CIO to develop strategic asset allocations. We adapted this methodology to incorporate specific con-siderations for yield-focused SAAs. Risk factor analysis is based on more recent research, which has shown that most asset returns can be explained by a handful of systematic risk factors. In effect, these risk factors are responsible for most of the expected returns and risks inherent in a portfo-lio, and thus must be carefully evaluated to ensure portfolio efficiency.

An Efficient Frontier for Yield-Focused PortfoliosAn efficient frontier is the set of portfolios that maximize the expected total return for a given level of risk. Each portfolio on the efficient frontier represents a different mix of indi-vidual asset classes. It is the outcome of the mean-variance optimization process, which requires assumptions only for expected returns, volatilities, and correlations. The result is an efficient frontier as illustrated in Fig. 1.

To construct efficient yield-focused portfolios we replaced estimated returns with estimated yields for each asset class. The rationale is that investors who desire high and consistent income are likely to care at least as much about the portfo-lio income level and risk as they do about the total returns. Consequently, a conventional efficient frontier based on total returns may be suboptimal for yield-seeking investors. How-ever, the optimization still employed total return volatilities and correlations since these investors are also likely to care about significant declines in the total portfolio value.1 After deriving the yield-focused portfolios, their estimated total returns were determined by applying the allocation weights to the CMA total estimated returns for each asset.

The yield-focused portfolios should be more efficient than typical balanced income-generating portfolios because their optimization process includes a larger set of assets with relatively low correlations. Typical income portfolios allocate to only a subset of all assets, primarily conventional fixed income and high-dividend yield stocks. By including a greater variety of equities and other less conventional assets, the efficient frontier is pushed higher, which means investors can expect more income for a given amount of risk taken. Note that it is inaccurate to compare these yield-focused portfolios to total return-based efficient frontier portfolios. The two frontiers are derived assuming different investor preferences. An efficient yield-focused portfolio may be suboptimal to a total return-focused investor, but not to one seeking higher income.

A Risk Factor Analysis of Yield GenerationRisk factor analysis is particularly relevant for constructing yield-focused portfolios. Investors can get income from many different types of assets, such as interest payments from bonds, dividends from stocks, or distributions from MLPs. But what matters for creating an efficient portfolio is that it has exposure to diverse underlying risk factors, not just diverse income-generating assets. Academic research has shown that non-diversifiable risk factors are the ultimate determinants of assets’ expected yields and returns. Inves-tors exposed to them are compensated with higher expected returns via factor risk premia.

Note: For illustrative purposes onlySource: UBS

Fig. 1: Efficient Portfolios Seek to Maximize Risk-AdjustedExpected Returns

Total Risk

Expectedreturn

Efficientfrontier

Individualassets

Efficientportfolios

1 As shown in Fig. 15, income volatility is very low over time compared to

price volatility and thus not a feasible input for the optimization process.

Constructing Efficient Yield-Focused Portfolios


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Evaluating asset sensitivity to these factors is critical for build-ing an efficient portfolio because the same risks can affect distinct assets. In particular, many assets have exposure to equity risk, which is why cross-asset correlations surge during market sell-offs. Consequently, a portfolio that looks diverse at the asset class level may actually be concentrated in one or two risk factors, leaving it vulnerable to corrections and its performance heavily reliant on a few distinct sources of expected return. While many potential risk factors have been identified, Fig. 2 describes the primary ones responsible for yields and returns above the risk-free interest rate.

The bottom line is that it’s not enough to increase the num-ber or variety of yield-generating assets in the portfolio, it’s also necessary to include more types of risk factors. That will improve diversification and portfolio resiliency across a vari-ety of economic circumstances. Failure to properly account for the possibility of common risk factor exposures could lead to riskier, suboptimal portfolios.

Fig. 2: Risk Factor Exposures for Yield-Focused Portfolio Assets

Risk Factors Description

Duration Duration refers to the sensitivity of a bond’s price to a change in the general level of interest rates, with the sensitivity increasing with the duration. Duration increases with a bond’s maturity and falls with its coupon rate, all else equal. The duration risk premium is the compensation for locking in for the long-term at current rates and thus bearing the risk of rising interest rates. While associated with fixed income, equities do have duration risk, which varies by sector.

Credit A credit risk premium is the reward for holding securities with higher default risk than safe government bonds. High credit risk fixed income securities have higher expected coupon payments to compensate for the higher probability of principal-loss.

Equity The equity risk premium is the excess expected return from investing in equities over the risk free Treasury rate. It’s the reward for taking on the higher risk of equities and probability of large capital losses.

Liquidity Investors who hold securities that have lower marketability and/or are absent from publicly-traded exchanges earn a liquidity risk premium. The premium stems from investors needing to be compensated for holding securities that cannot be quickly or easily sold.

Complexity Investors are rewarded with a risk premium for a security’s complexity or opaqueness of the market. This includes securities that require extra due diligence to assess their cash flow properties, control provisions, liquidity and marketability, and suitability as an investment.

Source: UBS

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Using the yield-focused framework outlined above, we designed five portfolios corresponding to the five UBS WM-US risk profiles, along with all-equity and all-income versions, which provide high recurring income without sac-rificing long-term total returns. The portfolios are well-diver-sified and look more like a conventional balanced portfolio consisting of bonds and stocks than a standard income port-folio, as evident in the tax-exempt portfolios shown in Fig. 3. Yet the portfolios’ assets, allocation weights, and yield, total return and total risk properties are distinct from these two other portfolio types.

This starts with the assets included in the portfolios, which fall into three broad categories: bonds, equities, and “yield” assets. Bonds include US government, corporate (invest-ment grade and high-yield), and emerging market (US dollar and local currency) debt. The equity allocation is to US large cap value and growth, international developed value, and emerging market stocks. These bond and equity asset classes are already used in the House View portfolios. The “yield” category includes senior bank loans, preferred securities (“bond-like” assets), MLPs2, and REITs (the latter two being “equity-like” securities) and have previously not been used in House View portfolios.3

At a high level, the allocations reflect the goal of increas-ing the yield from a balanced portfolio without sacrificing total returns. That’s why the new yield assets are included and why the allocations in the bond and equity categories tilt towards higher yielding assets compared to the current House View portfolios (e.g., higher relative weights of high-yield to government bonds). In order to remain compliant with the UBS risk profile risk-bands, we still assigned sizeable allocations to assets with lower yields but historically high total returns, while those with high yields didn’t necessar-ily get high allocations. This is also why the total equity and “equity-like” yield asset allocations far exceed those for tra-ditional income portfolios.

The efficiency of these portfolios is evident in both forward-looking market expectations and by how these portfolios could have performed historically, which is reviewed in the Performance Risks section. The estimated performance is based on the current UBS Capital Market Assumptions (CMAs), which were used in the portfolio optimization pro-cess. The bottom of Fig. 3 lists the estimated future total returns and total risks, measured by portfolio volatility, for the yield-focused portfolios. They are very similar to those for the House View portfolios, which was by design, as the same total risk was targeted in the optimization process.4

The Yield-Focused Portfolios

2 The inclusion of MLPs in a tax-exempt or tax-deferred account may expose investors to potential tax issues. See Appendix 2 for reports providing details on the use of MLPs in these circumstances.

3 Only assets with liquid publicly-listed securities were considered for the SAA. This ruled out income-generating strategies such as covered call writing, even though they can provide a steady source of income with a negative correlation to equities because the payoff is higher when price appreciation is lower and the stocks aren’t called.

4 The CMAs are forward-looking estimates determined at a point in time, and are apt to change as economic and market conditions evolve. They are not intended to be assured return outcomes.


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Fig. 3: Tax-exempt Yield-Focused Portfolios

Asset Class Conservative Moderately Conservative

Moderate Moderately Aggressive

Aggressive All Equity All Income

Cash 3% 3% 3% 3% 3% 3% 3%

Fixed Income 65% 56% 43% 30% 12% 0% 77%

US Gov’t 30% 16% 10% 5% 5% 0% 18%

US MBS 0% 0% 0% 0% 0% 0% 5%

US IG corp 18% 16% 6% 2% 0% 0% 20%

US HY corp 12% 14% 16% 15% 5% 0% 15%

EM US Dollar 3% 5% 5% 2% 0% 0% 8%

EM Local currency 2% 5% 6% 6% 2% 0% 11%

Equities 12% 21% 34% 47% 62% 77% 0%

US Large cap Growth 2% 3% 4% 5% 6% 7% 0%

US Large cap Value 4% 7% 11% 14% 18% 32% 0%

Int’l Developed Value 6% 11% 16% 22% 29% 28% 0%

Emerging Markets 0% 0% 3% 6% 9% 10% 0%

Yield Assets 20% 20% 20% 20% 23% 20% 20%

Senior Loans 6% 4% 2% 0% 0% 0% 15%

Preferreds 10% 7% 6% 4% 2% 0% 5%

MLPs 4% 7% 10% 13% 16% 16% 0%

US REITs 0% 2% 2% 3% 5% 4% 0%

SAA Estimates

Yield 3.6% 4.0% 4.2% 4.2% 3.8% 3.5% 3.7%

Total Return 4.0% 5.0% 6.0% 6.9% 7.8% 8.3% 3.6%

Yield/Return Ratio 89% 80% 70% 61% 49% 42% 101%

Total Risk 4.3% 6.3% 8.5% 10.7% 12.5% 13.9% 3.5%

Note: Total return and total risk estimates are based on the UBS Capital Market Assumptions. Yield is estimated using a blend of current and historical yields. Yields were approximated using fund proxies that we believe are representative of the asset class – see Appendix for methodology notes.Source: UBS

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portfolios and the high equity allocation in the Aggressive portfolio dampen their total yields. Across the five risk profiles, the estimated yields for the yield-focused portfolios range from 35% to 90% greater than those for the House View portfolios. Fig. 5 compares the SAAs, plotting each based on estimated yield and total risk.

The portfolios in Fig. 3 are designed for tax-exempt inves-tors, whereas those in Fig. 6 are intended for taxable inves-tors. The two SAAs are very similar. Municipal bonds are part of the taxable portfolios, which is the only difference in the assets included in both. The muni allocations are funded almost entirely by reducing the US government bond and investment grade credit allocations. Despite munis’ tax advantage, the after-tax yields for high-yield and emerging market debt are typically at least as high and therefore their allocations don’t fall in the taxable portfolios. The Appendix has more details on how the taxable SAAs were derived, as they required an after-tax efficient frontier.

Yield forecasts are not part of the CMAs, so we constructed multi-year expected yields in order to derive a yield-focused efficient frontier. Unlike expected total returns, yields are observable in market prices, which served as the starting point for our yield forecasts. We combined current yields with trailing average realized yields to create the forecasted, or expected, yields. We view these forecasts as a good esti-mate of the annual income investors can expect to earn, especially over the next year. Expected yields were calculated for all assets considered for the portfolios, while Fig. 4 shows these yields for the final portfolio assets. More details on the yield estimation methodology are in Appendix 1.

The estimated yields for these portfolios, based on these forecasted asset class yields, are also listed in Fig. 3. The yields are high, accounting for at least half of the estimated total return for all risk profiles, except for the Aggressive portfolio. The yields peak in the Moderate and Moderately Aggressive portfolios. The high allocation to low-yielding but high credit-quality bonds in the Conservative

Note: Yields were approximated using fund proxies that we believe are representative of the asset class – see Appendix for methodology notes.Source: Bloomberg, UBS

Int’l Developed Value

Emerging Markets

US Large cap Growth

US Large cap Value

US Gov’t

US MBS

US Munis

US IG corp

US HY corp

EM US Dollar

EM Local currency

Cash

MLPs

US Real Estate

Senior Loans

Preferreds

Estimated Yield

2 64 8 100

Fig. 4: Estimated Yields for the Yield-Focused Portfolio Assets

In %

Yield-Focused

Estim

ated

Yie

ld

3

2

1

0

4

5

6

0 2 4 6Total risk (volatility)

Conservative

Conservative

ModeratelyConservative


Moderate

Moderate

ModeratelyAggressive

ModeratelyAggressive

Aggressive

Aggressive

108 1412 16

Fig. 5: Estimated Yield and Total Risk for the Yield-

Focused and House View PortfoliosIn %

House View

Note: Total return and total risk are based on the UBS Capital Market Assumptions. Estimated yield is estimated using a blend of current and historical yields. Yields were approximated using fund proxies that we believe are representative of the asset class – see Appendix for methodology notes.Source: UBS


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Fig. 6: Taxable Yield-Focused Portfolios

Asset Class Conservative Moderately Conservative

Moderate Moderately Aggressive

Aggressive All Equity All Income

Cash 3% 3% 3% 3% 3% 3% 3%

Fixed Income 65% 56% 43% 30% 12% 0% 77%

US Gov’t 25% 15% 6% 3% 3% 0% 13%

US MBS 0% 0% 0% 0% 0% 0% 0%

US Munis 23% 14% 6% 3% 3% 0% 30%

US IG corp 4% 4% 4% 0% 0% 0% 0%

US HY corp 9% 15% 16% 16% 4% 0% 15%

EM US Dollar 4% 5% 5% 2% 0% 0% 9%

EM Local currency 0% 3% 6% 6% 2% 0% 10%

Equities 12% 21% 34% 47% 62% 77% 0%

US Large cap Growth 2% 3% 4% 6% 6% 7% 0%

US Large cap Value 4% 8% 12% 15% 18% 32% 0%

Int’l Developed Value 6% 10% 15% 21% 29% 28% 0%

Emerging Markets 0% 0% 3% 5% 9% 10% 0%

Yield Assets 20% 20% 20% 20% 23% 20% 20%

Senior Loans 6% 4% 2% 0% 0% 0% 15%

Preferreds 10% 7% 7% 5% 2% 0% 5%

MLPs 4% 7% 9% 12% 16% 16% 0%

US REITs 0% 2% 2% 3% 5% 4% 0%

SAA Estimates

Yield 3.3% 3.8% 4.1% 4.2% 3.8% 3.5% 3.9%

Total Return 3.8% 4.9% 5.9% 6.9% 7.8% 8.3% 3.4%

Yield/Return Ratio 88% 79% 70% 61% 49% 42% 115%

Total Risk 4.1% 6.1% 8.4% 10.6% 12.5% 13.9% 3.7%

Note: Total return and total risk are based on the UBS Capital Market Assumptions. Yield is estimated using a blend of current and historical yields. Yields were approximated using fund proxies that we believe are representative of the asset class – see Appendix for methodology notes.Source: UBS

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Driving the correlations for all asset classes are their various risk factor exposures. Assets heavily exposed to equity risk, such as high-yield bonds, will tend to be highly correlated with US equities. Likewise, many other assets that have sensitivity to interest rates (i.e., have high duration risk) will trade closely with US government bonds. Thus, assets with relatively low correlation should be exposed to differing risk factors. Precisely quantifying such exposures is difficult, espe-cially for the liquidity and complexity risk factors. Yet those two factors are likely prevalent in the yield asset classes, which are comparatively niche relative to the overall securi-ties market (both in size and ownership) with a high degree of asset-specific risk. That contributes to their relatively low correlations, which is essential for the portfolios’ ability to increase yield and maintain total returns without increas-ing overall risk. The benefit of adding the yield assets to the portfolios is evident in their impact on the efficient frontier (Fig. 8). Including them in the portfolio with fixed income and equity assets lifts the yield-focused efficient frontier sig-nificantly higher, offering higher estimated yields without the need to take on additional risk.

These portfolios are able to offer high estimated yields and total returns without taking excessive risk because of their diversified asset and risk exposures. An assets’ risk contribu-tion to the portfolio was a key consideration in the portfolio construction process. Consequently, the asset allocations are not that sensitive to modest changes in the estimated yield assumptions, even though the yield-focused efficient frontier maximizes the estimated yield per unit of risk. The reason for the relative insensitivity is that each portfolio targeted a cer-tain level of total risk, and thus assets’ risk attributes, correla-tions in particular, were just as influential as their estimated yields in determining the allocations.

The historical correlations shown in Fig. 7 illustrate why this is true. US equities and government bonds are negatively correlated, which is the basis of diversification in a balanced portfolio. Adding assets to the bond and equity categories increases diversification, though with diminishing benefits because their correlations to stocks and government bonds are usually still significant. For instance, high-yield bonds have a fairly high correlation with equities, which tends to increase in market sell-offs, while investment grade bonds trade more in-line with government bonds. The yield-focused portfolios improve upon this outcome because the additional yield asset classes have relatively lower correlations to both equities and bonds, but especially to each other. Including them actually brings down total portfolio risk, while also adding to the expected yield.

Diversification and Risk Sensitivities

Fig. 7: Yield Assets Have Relatively Low Correlations

IG Corp HY Corp LC Value Preferreds MLPs REITS

US Gov’t 0.68 –0.05 –0.10 0.13 –0.08 –0.07

IG Corp 0.38 0.25 0.55 0.13 0.21

HY Corp 0.67 0.46 0.45 0.52

LC Value 0.38 0.49 0.64

Preferreds 0.22 0.31

MLPs 0.39

Note: Correlations are based on rolling 30-day returns, estimated from 2000 to 2017. Source: Bloomberg, UBS

Source: Bloomberg, UBS

With Yield Assets

Without Yield Assets

4

3

0

1

2

5

0 5 10 15 20

Fig. 8: Yield Assets Raise the Yield-Focused Efficient Frontier

In %


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The bottom line is that adding more assets to the portfolio doesn’t necessarily improve diversification if more risk factor exposures aren’t also added. That’s the purpose of broad-ening out the equity allocation and including more distinct types of yield-generating assets that diversify risk exposures. Including the latter actually enables larger allocations to the higher yielding assets in the bond category—i.e., high yield and emerging market debt—without increasing the total or overall risk. The diversity in risk factor exposures should also make these portfolios more resilient to evolving and uncer-tain macroeconomic conditions.

Within equities, allocating to US growth stocks and emerg-ing markets, despite lower dividend yields, increases the exposure to pure equity and growth risk, while raising the expected total return for the portfolios. This differs from typical income-generating portfolios that concentrate in high-dividend paying stocks, such as utilities. These “bond-proxies” have high sensitivity to interest rate risk and help to satisfy the yield objective, but not the total return goal. Aside from helping with this goal, growth and EM stocks actually diversify the portfolio because their yield and returns stem primarily from equity risk. Still, the yield-focused portfolios do favor value over growth stocks, in the US and for inter-national developed equities, because the dividend-yield for value is about one percentage point higher than for growth stocks.

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On paper, the yield-focused portfolios have appealing expected yield / total return / total risk properties based on forward-looking CMAs. Historically simulated cumula-tive total returns also suggest that they would have done quite well over the past 20 years, generating significant capital appreciation in addition to providing steady income (Fig. 9).5 But simulating the performance of these portfo-lios also revealed that they’re exposed to significant tail risks – in some cases, more so than the House View portfolios.Thus, these yield-focused portfolios are not appropriate for income-seeking investors focused primarily on capital preser-vation and those who have low tolerance for portfolio losses.

Fig. 10 illustrates simulated historical total returns for the Moderate tax-exempt yield-focused and House View portfo-lios. In this simulation the returns are indexed to 100 on 31 December 2009. From that date onward the returns were comparable, while the yield-focused portfolio had modestly higher relative performance prior to 2010. This was driven by two circumstances. First, the yield-focused portfolio fared much better after the Tech Bubble, owing to its lower overall exposure to US equity risk. Second, MLPs and REITs had strong performance during this period as they were still maturing as asset classes and were bolstered by the bull mar-kets in oil and real estate.

Performance Risks

5 These simulated returns are a hypothetical analysis based on historical asset class returns. This backward-looking illustration assumes an invest-ment in asset class indexes represented by the indicated Strategic Asset Allocation (SAA) portfolios. These performance calculations assume a static asset allocation, don’t take into account any prior SAA for this investor profile, and include time periods before the SAAs were created. See the latest UBS House View: Investment Strategy Guide (ISG) for the detailed SAA of the taxable portfolio without non-traditional assets. For periods prior to 2009, this illustration assumes that the Bloomberg Barclays EM Local Currency Government Total Return Index allocation (inception date of 4 July 2008) was invested fully in the Bloomberg Barclays EM USD Aggregate Total Return Index. This data is used for illustration purposes only, and due to differing assumptions will not match the performance measurement published in the ISG.

Fig. 9: The Yield-Focused Portfolios Offer a Mix of Income and Price Appreciation

Note: See footnote 5 for an explanation of the simulation assumptions. Source: Bloomberg, UBS, as of 28 February 2018

Components of total return based on historical simulations,moderate risk tax-exempt yield-focused portfolio, in $

150

100

50

0

–50

200

Price appreciation Income

Reinvestment Total Return

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017


80604020

0

180160140120100

200

House View

Yield-Focused

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Fig. 10: Yield-Focused and House View Portfolios Have Comparable Simulated Performance

Cumulative Total Returns to Tax-Exempt Moderate Portfolio, indexed to 31 December 2009


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We don’t look for the yield-focused portfolios to outperform the House View portfolios going forward. Simulated returns since mid-2016, when the 10-year Treasury yield bottomed at 1.4%, are indicative of potential relative performance, in our view, with the yield-focused portfolio lagging modestly (Fig. 11). Even though interest rates rose significantly over this period, the yield-focused portfolio was dragged down primarily by the underperformance of US large-cap value ver-sus growth equities and MLPs.

Overall, the yield-focused portfolios had similar volatility and drawdowns to the House View portfolios over the full simu-lated sample period from 31 December 1998 to 28 February 2018. But as Fig. 12 indicates, some economic environments are more favorable to one type of portfolio than the other. For example, during the bear market in the early 2000s the yield-focused portfolio was more resilient because of its smaller total equity allocation. The figure provides additional evidence that the yield-focused portfolio doesn’t perform relatively worse when interest rates are rising. During the “taper tantrum” in the spring and summer of 2013 both portfolios saw comparable drawdowns.

Nonetheless, there are tail risks specific to the yield-focused portfolios that make them more vulnerable during peri-ods of financial market stress, during periods of monetary

tightening and rising interest rates, and when there are extended liquidity gaps in the markets. These risks include:

1. Negatively skewed returns: Returns to income-gener-ating assets, and therefore yield-focused portfolios, tendto be more negatively skewed than a typical balancedportfolio. To understand why, consider high-yield cor-porate bonds. Their coupon payments constitute almostthe entire total return when yields and spreads are stableand not trending. That is, investors earn a steady positivereturn as they “clip the coupon”. But when economicconditions deteriorate and spreads widen significantly,the returns will be very low or negative over that period.Combining multiple periods of steady positive returnswith occasional poor returns results in a negativelyskewed return distribution. Fig. 13 illustrates this for high-yield bonds, but the pattern is similar for other assets inwhich income accounts for most of the total return.

2. Illiquidity: The yield asset classes, especially preferredsand MLPs, are smaller and less liquid than large-cap equi-ties and government bonds. Thus, they’re vulnerable tolarge price swings, especially in stressed market condi-tions, increasing the portfolio drawdown risk. But liquiditygaps also adversely affect high yield and emerging marketbonds.

Fig. 11: House View SAA Simulated Returns Since Mid-2016are Modestly Better


Cumulative Total Returns to Tax-Exempt Moderate Portfolio,indexed to 30 June 2016

110

105

100

95

90

120

115

125

House View

Yield-Focused

Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17

Fig. 12: The Yield-Focused Portfolio Performed RelativelyBetter in Some Periods Than Others

Drawdowns to Tax-Exempt Moderate Yield-Focused and House ViewPortfolio, in %


–20

–25

–30

–35

–40

–5

–10

–15

0

House View

Yield-Focused

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

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3. High asset-specific risk: MLPs, preferreds, and REITshave asset-class specific risks that don’t get fully diversi-fied in the SAA because of their significant allocations,and these risks can adversely sway portfolio performance.For example, falling oil prices from 2014 to 2016 weighedheavily on MLPs, even though their profitability should befairly immune to oil price fluctuations, and on high-yieldbonds. This resulted in a larger drawdown in the yield-focused portfolio during this period (see Fig. 12).

A counter to the higher tail risks for the yield-focused port-folios is that – assuming their higher income stream is rein-vested – they tend to recover more quickly from selloffs than their traditional counterparts. In our historical simulation, this is particularly true for the more aggressive risk portfolios (Fig. 14). But it’s important to note that for all investment strategies risk characteristics such as time under water and drawdowns are affected by flows into and out of the port-folio. Investors who are able to add to their portfolio, or reduce the pace of withdrawals during downturns, will enjoy a faster recovery time, while portfolio outflows can detract from the portfolio’s compound growth and impede its recov-ery speed.

Reliability of returns is one advantage of a portfolio whose income is a larger share of total return. Although individual asset classes’ income can vary somewhat, the yield-focused portfolio’s diversified approach smooths out these variations, resulting in relatively consistent income illustrated in Fig. 15. This is an important consideration, because it translates into a lower effective risk for investors who are focused on the income stream and whose time horizon allows them to leave the portfolio principal untouched.

Note: Monthly returns are measured from December 1998 to August 2017Source: Bloomberg, UBS

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2.7%and

higher

Fig. 13: High-Income Assets’ Higher Negative “Skew”Results in a Higher Occurrence of Large Losses

Histogram of monthly returns, US high-yield corporate bonds

Note: See footnote 5 for an explanation of the simulation assumptions. Source: Bloomberg, UBS

50

40

30

20

10

0

60

70

28

61

39


Conservative ModeratelyAggressive

AggressiveModerate

Fig. 14: Simulated Time-Under-Water is Less forYield-Focused Portfolios

Maximum “time under water” (recovering from a drawdown) sinceDecember 1998, in months

1614

24 25

35

44

35

House View

Yield-Focused

Fig. 15: By Diversifying Its Exposure, the Yield-FocusedPortfolio Offers Reliable Income

Note: See footnote 5 for an explanation of the simulation assumptions. Yields were approximated using fund proxies that we believe are representative of theasset class – see Appendix for methodology notes.Source: Bloomberg, UBS

1-month rolling returns, moderate risk tax-exempt yield-focusedportfolio, in %

4

0

–4

–8

–12

8

12

Price

Income

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017


14 of 19 March 2018


Having an efficient portfolio option that emphasizes both income and total returns is likely to become more important in the coming years. Notably, investor demand for income is growing and demographic trends suggest that this will con-tinue. In addition, the long-term outlook for returns across asset classes has declined over the past decade as valua-tions have increased. Consequently, the percentage of total returns contributed by income relative to capital gains should rise over the next decade, even if yields stay low. All of this will make it more challenging for investors to meet their future liabilities and goals.

We think these yield-focused portfolios offer a good alterna-tive for investors who seek more income without a material sacrifice in capital appreciation potential. By constructing efficient portfolios with diverse sources of returns, the aim is to maximize the estimated yield and total return for the amount of risk taken. Thus, they should be superior to an ad hoc addition of higher yielding assets to an existing portfolio.

We acknowledge the limitations of historical simulations, and some investors may be well-served by incorporating deviations from these model portfolios in order to account for tax considerations, transaction costs, and other con-straints. Please contact your UBS Financial Advisor to discuss whether these portfolios can be useful as a tool in meeting your family’s financial goals.

Final Thoughts

March 2018 15 of 19

In order to build and optimize the yield-focused SAAs, we needed to develop an estimate of expected yield. Although the UBS Capital Market Assumptions (CMA) set forth esti-mated total return estimates for broad asset classes, these estimates don’t isolate capital appreciation from income return. Instead, we used current and historical yields to develop forward-looking yield estimates. This required a number of assumptions in order for the yield estimates to be consistent and comparable across asset classes and to reflect the actual investor experience.

First, we chose to use funds to calculate yields rather than a stated yield on an index benchmark. Index construction often doesn’t account for transaction costs or implementation, so for some asset classes there is no direct way of investing in the index. This tends to be due to liquidity considerations, and including less-liquid investments can often result in a higher apparent yield than an investor can access. Instead, we looked at a variety of funds that we believe are effective proxies for the return, risk, and income characteristics of each asset class. For some asset classes, we used a blend of fund proxies in order to ensure a full and representative history.

Second, to have a consistent yield measure we used Bloom-berg data to assess these funds’ historical “indicated divi-dend yield” – a methodology that is broadly consistent across asset classes because it is based on actual fund cash flows. To smooth out “lumpy” cash flows, we took a 12-month trailing average of the indicated yield.

Third, to account for the fact that recent asset class yield observations are near record lows, and are likely to rise over time, we used a blend of currently-observed and average trailing yields. Our estimated yield figures are a blend of the indicated yield and an average of indicated yields over the past 10 years. We view these forecasts as a good estimate of the annual income investors can expect to earn from each asset class.

The resulting estimated yields across asset classes are those shown in Fig. 4. Asset class income tends to be relatively stable – for example, dividend policy changes tend to be gradual at the S&P 500 index level – but the observed yield will be more volatile. First, because income payments can be “lumpy” (bonds usually pay income semi-annually, while div-idend payments tend to be quarterly). Second, because and asset’s price sits in the denominator of the yield calculation, so the observed yield fluctuations with market movements.

There are important considerations to bear in mind regarding these estimated yields. First, we did not fully incorporate the impact of taxes. Every investor’s tax situation is unique, and for some of the asset classes, such as MLPs, the effective tax rate may vary based on the investor and the implementation. Thus, we incorporated taxes by applying a simple “tax hair-cut” to our pre-tax yield estimate of each asset class: [pre-tax yield x (1- top marginal tax rate) = after-tax yield]. Tax hair-cuts differed by each asset class based on the specific type of income that it produces. In general, interest income is taxed as ordinary income (37% top rate + 3.8% ACA surtax = 40.8%), while dividends enjoy a lower rate (20% top rate + 3.8% ACA surtax = 23.8%), so bonds’ income tax haircut is generally larger than stocks’ income tax haircut. After-tax returns are also less volatile than pre-tax returns – losses are muted by the “tax credit” from capital losses, and gains are muted by capital gains taxes – so we incorporated after-tax volatilities into our portfolio optimization.

Second, portfolio cash flows can have a major impact. If an investor adds to the portfolio or allows income to be rein-vested, the portfolio’s income will compound over time. If the investor withdraws from the portfolio – either through harvesting capital appreciation or taking from portfolio cash flows – income will be more stagnant.

Appendix 1: Yield Estimation

Appendix 2: Implementing MLPs in tax-exempt Yield-Focused Portfolios

Owning individual MLPs in a tax-exempt or tax-deferred account may expose investors to potential tax issues stem-ming from Unrelated Business Taxable Income (UBTI). There-fore we strongly suggest seeking tax advice and reading our MLP Primer dated 26 January 2018 for additional details,

and MLP Investment Alternatives: One size does not fit all published on 7 March 2018, which discusses alternatives to owning individual MLPs, but still offering exposure to the asset class.


March 2018 16 of 19

Bibliography and Related Reading

Ang, A. Asset Management, Oxford University Press (2014).

Ang, A. and K. Hogan. “Macroeconomic Factors: Important Diversifiers,” Blackrock (February 2018).

Blanchett, D. and H. Ratner. “Building Efficient Income Portfolios,” The Journal of Portfolio Management, Vol. 41, No. 3 (2015), pp. 117-125.

Clarke, Roger G., Harinda de Silva, and Robert Murdock. “A Factor Approach to Asset Allocation,” Journal of Portfolio Management, Vol. 32, No. 1 (2010), pp. 10–21.

Draho, J., J. Dobson, R. Sutedja, and J. Waring. “MLPs in a Diversified Portfolio,” UBS, June 2016.

Harvey, C., Y. Liu, and H. Zhu. “…and the Cross-Section of Expected Returns,” Review of Financial Studies, Vol. 29, No. 1 (2016), pp. 5-68.

Illmanen, A., Expected Returns, Wiley (2011).

Koester, A. et al. “Strategic Asset Allocation Methodology and Portfolios”, Investing with UBS Wealth Management February 2018.

Markowitz, H. M. “Portfolio Selection,” The Journal of Finance, Vol. 7, No. 1 (1952), pp. 77-91.

Martellini, L. and V. Milhau. “Proverbial Baskets are Uncorrelated Risk Factors! A Factor-Based Framework for Measuring and Managing Diversification in Multi-Asset Investment Solutions,” Journal of Portfolio Management Vol. 44, No. 2 (2018), pp. 8-22.

Principal Financial Group / CREATE, Asset Allocation: Survival of the Fleetest, (2015).

UBS WM-US, “2017 Strategic Asset Allocations and Capital Market Assumptions Update,” February 2017.


17 of 19 March 2018


DisclaimerThis material is published solely for informational purposes, may be distributed only under such circumstances as may be permitted by appli-cable law, and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. This information is general in nature and does not take into account the specific investment objectives, financial situation or particular needs of any recipient.

All information and opinions represent our current views on the topics covered which are based, in part, on information and data obtained from third party and/or publicly available sources. While we believe those sources to be reliable, no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates) of that information.

The information presented is not intended to be a complete statement or summary of the securities, markets or developments referred to in the materials. It should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this material are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or groups of UBS as a result of using different assumptions and criteria. UBS is under no obligation to update or keep current the information contained herein.

Cautionary statement regarding forward-looking statements. This report contains statements that constitute “forward-looking state-ments”, including but not limited to statements relating to the current and expected state of the securities market and capital market assump-tions. While these forward-looking statements represent our judg-ments and future expectations concerning the matters discussed in this document, a number of risks, uncertainties, changes in the market, and other important factors could cause actual developments and results to differ materially from our expectations. These factors include, but are not limited to (1) the extent and nature of future developments in the US market and in other market segments; (2) other market and macro-economic developments, including movements in local and international securities markets, credit spreads, currency exchange rates and interest rates, whether or not arising directly or indirectly from the current mar-ket crisis; (3) the impact of these developments on other markets and asset classes. UBS is not under any obligation to (and expressly disclaims any such obligation to) update or alter its forward-looking statements whether as a result of new information, future events, or otherwise.

Wealth Management Americas Asset Allocation Committee and the UBS Capital Market Assumptions and Strategic Asset Alloca-tion Models The capital market assumptions and strategic asset allocation modelsdiscussed in this publication were vetted and approved by the WealthManagement Americas Asset Allocation Committee (WMA AAC). TheWMA AAC is comprised of the following members: Mike Ryan (Chair),Jeremy Zirin, Michael Crook, Tom McLoughlin, Jason Draho, LeslieFalconio, David Lefkowitz, Brian Rose, Laura Kane.

The capital market assumptions are estimates of forward-looking average annual returns for a particular asset class. They are not guaranteed and do not represent the return of a particular security or investment.

Important Information and Disclosures

The strategic asset allocation models are intended to provide a general framework to assist our clients in making informed investment decisions. They are provided for illustrative purposes, and were designed by the WMA AAC for hypothetical U.S. investors with a total return objec-tive under five different investor risk profiles: conservative, moderate conservative, moderate, moderate aggressive and aggressive. Your UBS Financial Services Inc. Financial Advisor can help you determine how a strategic allocation could be applied or modified according to your individual profile and investment goals.

Asset allocation does not assure profits or prevent against losses from an investment portfolio or accounts in a declining market.

Please note that UBS has changed its capital market assumptions and strategic asset allocation models in the past and may do so in the future.

Investment Risks Asset Class is a term that broadly defines a category of investments that share common investment characteristics. Typical broad asset classes include equities, fixed income securities, cash and cash alternatives. This section describes some of the asset classes used in this report and some of the general risk considerations. All investments involve risks which you should carefully consider prior to implementing an investment strategy.

Cash: Cash and cash alternatives typically include money market securi-ties or three-month T-Bills. These securities have short maturity dates and they typically provide a stable investment value as compared to other investments and current interest income. These investments may be subject to credit risks and inflation risks. Treasuries also carry liquidity risks for sales prior to maturity. Investments in money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Cor-poration (FDIC), the U.S. government or any other government agency. There can be no assurance that the funds will be able to maintain a stable net asset value at $1.00 per share or unit.

Equities: Equity securities are subject to market risk and will undergo price fluctuations in which downward and upward trends may occur over short or extended periods. Historically, equities have shown greater growth potential than other types of securities, but they have also shown greater volatility. In addition to these risks, securities issued by small-cap companies may be relatively highly volatile because their earnings and business prospects typically fluctuate more than those of larger-cap com-panies. Securities issued by non-U.S. companies can have risks not typi-cally associated with domestic securities, including risks associated with changes in currency values, economic, political and social conditions, loss of market liquidity, the regulatory environments of the respective countries and difficulties in receiving current or accurate information.

Fixed Income: Fixed Income represents debt issued by private corpora-tions, governments or Federal agencies. Two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. High yield invest-ments are high yielding securities but may also carry more risk. A bond fund’s yield and value of its portfolio fluctuate and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.

March 2018 18 of 19

Corporate Bonds: Fixed income securities are subject to market risk and interest rate risk. If sold in the secondary market prior to maturity, investors may experience a gain or loss depending on interest rates, market conditions and issuer credit quality.

Municipal Securities: Income from municipal bonds may be subject to state and local taxes based on residency of the investor and may be subject to the Alternative Minimum Tax. Call features may exist that can impact yield. If sold prior to maturity, investments in municipal securities are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer.

Foreign Exchange/Currency Risk: Investors in securities of issuers lo-cated outside of the United States should be aware that even for securi-ties denominated in U.S. dollars, changes in the exchange rate between the U.S. dollar and the issuer’s “home” currency can have unexpected effects on the market value and liquidity of those securities. Those secu-rities may also be affected by other risks (such as political, economic or regulatory changes) that may not be readily known to a U.S. investor.

Emerging Markets: Investing in emerging market securities can pose some risks different from, and greater than, risks of investing in U.S. or developed markets securities. These risks include: a risk of loss due to political instability; exposure to economic structures that are gener-ally less diverse and mature, and to political systems which may have less stability, than those of more developed countries; smaller market capitalization of securities markets, which may suffer periods of relative illiquidity; significant price volatility; restrictions on foreign investment; and possible repatriation of investment income and capital.

Non-Traditional Asset Classes: Non-traditional asset classes are alternative investments that include hedge funds, private equity, and private real estate, (collectively, alternative investments). Interests of alternative investment funds are sold only to qualified inves-tors, and only by means of offering documents that include information about the risks, performance and expenses of alternative investment funds, and which clients are urged to read carefully before subscrib-ing and retain. An investment in an alternative investment fund is speculative and involves significant risks. Specifically, these investments (1) are not mutual funds and are not subject to the same regulatory requirements as mutual funds; (2) may have performance that is volatile, and investors may lose all or a substantial amount of their investment; (3) may engage in leverage and other speculative in-vestment practices that may increase the risk of investment loss; (4) are long-term, illiquid investments, there is generally no secondary market for the interests of a fund, and none is expected to develop; (5) interests of alternative investment funds typically will be illiquid and subject to restrictions on transfer; (6) may not be required to provide periodic pric-ing or valuation information to investors; (7) generally involve complex tax strategies and there may be delays in distributing tax information to investors; (8) are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits.

Interests in alternative investment funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insur-ance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period

of time before making an investment in an alternative investment fund and should consider an alternative investment fund as a supplement to an overall investment program.

In addition to the risks that apply to alternative investments gener-ally, the following are additional risks related to an investment in these strategies:

• Hedge Fund Risk: There are risks specifically associated with invest-ing in hedge funds, which may include risks associated with investingin short sales, options, small-cap stocks, “junk bonds,” derivatives,distressed securities, non-US securities and illiquid investments.

• Managed Futures: There are risks specifically associated withinvesting in managed futures programs. For example, not all manag-ers focus on all strategies at all times, and managed futures strate-gies may have material directional elements.

• Real Estate: There are risks specifically associated with investing inreal estate products and real estate investment trusts. They involverisks associated with debt, adverse changes in general economic orlocal market conditions, changes in governmental, tax, real estateand zoning laws or regulations, risks associated with capital callsand, for some real estate products, the risks associated with theability to qualify for favorable treatment under the federal tax laws.

• Private Equity: There are risks specifically associated with investingin private equity. Capital calls can be made on short notice, and thefailure to meet capital calls can result in significant adverse conse-quences including, but not limited to, a total loss of investment.


19 of 19 March 2018


Disclaimer

Research publications from Chief Investment Office Americas, Wealth

Management, formerly known as CIO Wealth Management Research, are

published by UBS Wealth Management and UBS Wealth Management

Americas, Business Divisions of UBS AG or an affiliate thereof (collectively,

UBS). In certain countries UBS AG is referred to as UBS SA. This publication

is for your information only and is not intended as an offer, or a solicitation

of an offer, to buy or sell any investment or other specific product. The

analysis contained herein does not constitute a personal recommendation

or take into account the particular investment objectives, investment strate-

gies, financial situation and needs of any specific recipient. It is based on

numerous assumptions. Different assumptions could result in materially

different results. We recommend that you obtain financial and/or tax advice

as to the implications (including tax) of investing in the manner described

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information and opinions expressed in this document were obtained from

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warranty, express or implied, is made as to its accuracy or completeness

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