managing funding ratio risk and return aaron h. meder, fsa, ea senior asset-liability analyst, ubs...
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Managing funding ratio risk and return
Managing funding ratio risk and return
Aaron H. Meder, FSA, EA Senior Asset-Liability Analyst, UBS Global Asset Management
October 20, 2006
Not intended for public distribution. For important additional information, please see the Additional Disclosures at the end of the presentation.
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AgendaAgenda
• Current defined benefit challenges• Focus on funding ratio• Funding ratio risk and return management
process• Understanding liabilities• Develop a funding ratio risk budget• Implement risk budget• Monitor risk budget
• Appendix
Current defined benefit challenges
Current defined benefit challenges
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The asset-liability mismatchThe asset-liability mismatch
Source: UBS Global Asset Management, BloombergNote: Typical Asset Return represents 40% S&P 500 Index//10% Russell 2500 Index/10% MSCI EAFE Index/35% Lehman Brothers Aggregate Index/5% 3 Month T-Bills. Typical Liability Return represents the PBO of a typical pay-related defined benefit plan. Discount rate is the yield on the Moody’s Aa Corporate Bond Index. Assumes no contributions. Benefit payments and service cost are excluded from each year’s annual growth.
-20%
-10%
0%
10%
20%
30%
40%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Asset ReturnLiability return
Market-related Asset and Liability Returns 1994-2005
A good year or a bad year?
“Perfect storm”
-30%-20%-10%
0%10%20%30%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Difference between asset and liability returns
Asset-liability mismatch risk causes funding ratio volatility
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The asset-liability mismatch (cont’d)The asset-liability mismatch (cont’d)
Note: Liability represents the PBO of a typical pay-related defined benefit plan, with approximately 2.5% service cost. Discount rate is the yield on the Moody’s Aa Corporate Bond Index. Assumes no contributions. Includes benefit payouts
Sources of asset-liability mismatch
0% 5% 10% 15% 20% 25%
Equity
Interest Rate
Total market-related risk
Residual
Total Pension Risk
Managed through investment policy
Managed through funding and benefit
policies
Source: UBS Global Asset Management, Bloomberg
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2006Pension deficitsPension deficits
Note: Benefit payments were excluded from analysis.Source: UBS Global Asset Management
Liability expected to grow a steady 8%-9%
Key factors:
Passage of time (interest cost) = 5.5%-6.0%
Additional benefits earned (service cost) = 2.5%-3.0%
Fund must generate large enough returns to meet liabilities
0%
2%
4%
6%
8%
10%
12%
14%
16%
100% 90% 80% 70%
3-year5-year10-year
Liability relative return needed to close funding gap over various time horizons
Majority of plans have deficits; greater the deficit, greater the need for return
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Global pension reformGlobal pension reform
• Funding regulations• US: Pension Protection Act
• removes majority of smoothing of assets and liabilities• harsher penalties for being underfunded
• Canada: Pension Benefit Act• Solvency requirements focus on termination liability
• drives contribution requirements
• Accounting regulations• FASB and IASB working towards global
accounting regulations for pensions• Best guess is that they will take away much of
smoothing
Regulators moving to marked-to-market view of asset and liabilities
Our response: Focus on funding ratio
Our response: Focus on funding ratio
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Focus on funding ratio
Minimize FR volatility for a given level of FR return
The funding ratio, not level of assets in isolation, drives pension risk
Pension reform
Funding and accounting reform
begins 2006
Facing the challenges and “attacking the pension dragon”
Facing the challenges and “attacking the pension dragon”
Large return needs
Need for increased returns to keep
contributions at a tolerable level
Reduce the asset-liability mismatch
Causes include duration mismatch and equity market
risk
Challenges Our response
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Funding ratio approach vs. traditional approach
Funding ratio approach vs. traditional approach
Traditional Our approach: Funding ratio (A/L)
Objective Generate high long-term returns that will outperform the liability over the long term
Control the volatility of the plan’s funding ratio and outperform the liability over the long term
Risk measure Volatility of assets Volatility of funding ratio (assets vs. liabilities)
Low risk investment Aggregate bonds Liability mimicking asset portfolio
Process
Starts with assets
1. Develop portfolios that maximizes return and minimizes risk using CAPM
2. Determine acceptable level of asset volatility
3. Implement asset-only efficient portfolio
4. Monitor performance versus peers
Starts with liabilities
1. Analyze liabilities 2. Determine risk budget vs. liabilities 3. Implement combination of liability
mimicking assets with assets that are expected to outperform liabilities
4. Monitor funding ratio of plan
For illustrative purposes only.
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-1.5%
-0.5%
0.5%
1.5%
2.5%
3.5%
4.5%
2% 4% 6% 8% 10% 12% 14% 16%
Funding ratio risk
Fundin
g rat
io ret
urn
Measuring risk and return vs. the liability
Measuring risk and return vs. the liability
Funding ratio risk/return characteristics
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
Long Gov’t/Credit
Equities
Traditional 65/35 policy
Asset-only
frontie
r
Aggregate Bonds
Cash
Funding ratio frontier
Liability matching strategy
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Constructing efficient options Constructing efficient options
Hedge liabilities
Hedging component
Interest rate derivatives
Long duration bonds
Return generating component
Global diversification
Active “alpha” and “beta”
Return generation
For illustrative purposes only
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Liability hedging and return generation
Liability hedging and return generation
Combine liability hedging and return generation efficiently
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
2% 4% 6% 8% 10% 12% 14% 16%
Funding ratio risk
Fundin
g rat
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urn
Liability hedging
Return generation
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Policies structured relative to liabilities
Policies structured relative to liabilities
Need to eliminate uncompensated funding ratio risk
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
2% 4% 6% 8% 10% 12% 14% 16%
Funding ratio risk
Fundin
g rat
io ret
urn
Return generation
Equities
Traditional 65/35 policy
Funding ratio
frontie
r
Asset-only
frontie
rLong Gov’t/Credit
Aggregate Bonds
Liability matching strategy
Liability hedging
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The funding ratio risk management process
The funding ratio risk management process
ALM
• Understand liability risk and growth
• Understand how assets relate to liabilities
Understand liabilities 1
• Define efficient investment policies in an asset-liability framework
• Determine appropriate risk/return tradeoff
Develop funding ratio risk budget2
• Implement solution that best fits client preferences
• Assess investment policy in context of current market environment
Implement risk budget3
• Dynamically manage risk budget as a function of plan funding ratio
• Specific to each plan sponsors risk tolerance
Manage risk budget4
Source: UBS Global Asset Management
Process: Step 1 - Understanding the liabilities
Process: Step 1 - Understanding the liabilities
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Key pension liability risksKey pension liability risks
Assets Liabilities
Wage growth
Demographic experience (e.g. Longevity)
Inflation
Interest rates
Question: How should we best invest pension assets to cover for pension promises?
?
Answer: By taking compensated risk and hedging the uncompensated ones
For illustrative purposes only
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Assets Liabilities
Liability risks: Discount rateLiability risks: Discount rate
Changes in discount rates have a large impact on the value of liabilities
Discount rates determine the present value of the liabilities
If interest rates go down, the value of liability increases
Discounted future cash flows
For illustrative purposes only
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-
20
40
60
80
100
120
55 60 65 70 75 80 85
Age
Initial salary assumption Actual salary development
Liability risks: Salary growthLiability risks: Salary growth
Salary growth tends to move with inflation and economic real growth. Investing in equities and other real assets can
mitigate the impact of these risks
Best estimate of cash flows
Uncertainty due to salary
growth
Expected annuity payment, employee age 55
Source: UBS Global Asset Management
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20
40
60
80
100
120
140
65 70 75 80 85 90 95 100 105 110
Age
Initial benefit assumption Actual benefit development
Liability risks: InflationLiability risks: Inflation
The impact of inflation can be mitigated by investing in real rate bonds or other inflation-sensitive assets
There can be ad hoc or contractual benefit adjustments to inflationBest
estimate of cash flows
Uncertainty due to inflation
Expected annuity payment, employee age 65
Source: UBS Global Asset Management
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Fundamental FactorsReal RateInflation
Real GrowthAsset Risk Premia
Focus on fundamental exposures
Linking liabilities to assets Linking liabilities to assets
For illustrative purposes only.
Future Real Wage Growth
Future Wage Inflation
Active Accrued
Deferred
Retiree
Liability
Accru
ed
lia
bilit
y
Pro
jecte
d lia
bilit
y
Fundamental Exposures
InflationReal Growth
Interest Rates
Assets that mimic
Real Rate BondsEquities & Other Real Assets
Nominal Bonds
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Correlations between liabilities and cornerstone hedging assets
Linking liabilities to assets Linking liabilities to assets
Nominal Bonds Real Rate Bonds Equities
Future Real Wage Growth
0.25 0.20 0.80
Future Wage Inflation
0.75 0.80 0.20
Active Accrued
Deferred
Retiree
0.25
Acc
rued lia
bilit
y
Pro
ject
ed lia
bilit
y
0.85 0.55
This information is presented for illustrative purposes only and reflects UBS Global Asset Management’s expectations for prospective return and risk using current market assumptions. There is no assurance that these projections will ultimately be realized.
Process: Step 2- Developing a risk budget
Process: Step 2- Developing a risk budget
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Constructing efficient options Constructing efficient options
Hedge liabilities
Hedging component
Interest rate derivatives
Long duration bonds
Return generating component
Global diversification
Active “alpha” and “beta”
Return generation
For illustrative purposes only
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Example: Efficient optionsExample: Efficient options
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
Asset Allocation Current Current + Hedge
Option AHedge Liabilities /
Optimal Return Generation
Option BHedge Liabilities /
Optimal Return Generation
Option CHedge Liabilities /
Optimal Return Generation
Domestic Bonds 35% 0% 9% 7% 5%
Domestic Long Bonds 0% 25% 25% 40% 55%
Foreign Bonds 0% 0% 6% 5% 3%
Alternative Bonds 0% 0% 8% 5% 4%
Real Rate Bonds 0% 10% 18% 15% 13%
Domestic Equity 55% 55% 9% 7% 5%
Foreign Equity 10% 10% 8% 6% 4%
Emerging Mkt Equity 0% 0% 4% 3% 2%
Private Equity 0% 0% 5% 4% 3%
Hedge Funds (beta-neutral) 0% 0% 5% 4% 3%
Real Estate 0% 0% 5% 4% 3%
Liability Hedging Tools
Liability Hedge Ratio 13% 100% 100% 100% 100%
Asset Return
Market Return (beta) 7.4% 7.4% 6.9% 6.6% 6.4%
Active Return (alpha) 0.5% 0.5% 1.6% 1.3% 0.9%
Total Asset Return 7.9% 7.9% 8.5% 7.9% 7.3%
Funding ratio
Funding ratio return 1.9% 1.9% 2.5% 1.9% 1.3%
Funding ratio risk 12.0% 9.5% 7.0% 6.0% 5.0%
FR Sharpe Ratio 0.16 0.20 0.35 0.31 0.26
Funding ratio efficient portfolios
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0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
2% 4% 6% 8% 10% 12%
Funding ratio risk
Fundin
g rat
io ret
urn
Example: A range of efficient optionsExample: A range of efficient options
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
Funding ratio risk return characteristics
Liability matching strategy
A
B
C
Current (65/35)Return Generation
Liability hedging
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Example: Comparison of investment policies
Example: Comparison of investment policies
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
Expected funding ratio (One year, 95% confidence)
70%
75%
80%
85%
90%
95%
100%
105%
110%
115%
120%
Current Current +Hedge
Option A Option B Option C
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Example: Scenario analysis – funding ratio
Example: Scenario analysis – funding ratio
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
Policy: Current - 65% Equity, 12yr Duration mismatch
-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%
-30% 60% 65% 72% 82% 94% -30% 83% 83% 83% 83% 83%
-15% 67% 73% 81% 91% 105% -15% 87% 87% 87% 87% 87%
0% 74% 81% 90% 101% 117% 0% 90% 90% 90% 90% 90%
15% 82% 89% 99% 111% 128% 15% 93% 93% 93% 93% 93%
30% 89% 97% 108% 121% 140% 30% 97% 97% 97% 97% 97%
Policy: Option B - 20% Equity, 0 yr Duration mismatch Policy: Option C - 14% Equity, 0 yr Duration mismatch
-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%
-30% 85% 85% 85% 85% 85% -30% 86% 86% 86% 86% 86%
-15% 87% 87% 87% 87% 87% -15% 88% 88% 88% 88% 88%
0% 90% 90% 90% 90% 90% 0% 90% 90% 90% 90% 90%
15% 93% 93% 93% 93% 93% 15% 92% 92% 92% 92% 92%
30% 95% 95% 95% 95% 95% 30% 94% 94% 94% 94% 94%
Discount Rate Change (parallel shift) Discount Rate Change (parallel shift)
Equ
ity R
etur
n
Equ
ity R
etur
n
Policy Comparison: Sensitivity of Funding Ratio (%)
Discount Rate Change (parallel shift) Discount Rate Change (parallel shift)E
quity
Ret
urn
Equ
ity R
etur
n
Policy: Option A - 25% Equity, 0 yr Duration mismatch
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Example: Scenario analysis – surplus/(deficit)
Example: Scenario analysis – surplus/(deficit)
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
Policy: Current - 65% Equity, 12yr Duration mismatch Policy: Option A - 25% Equity, 0 yr Duration mismatch
-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%
-30% ($507) ($391) ($276) ($160) ($44) -30% ($211) ($189) ($168) ($146) ($124)
-15% ($415) ($302) ($188) ($74) $40 -15% ($169) ($151) ($134) ($116) ($99)
0% ($324) ($212) ($100) $12 $124 0% ($126) ($113) ($100) ($87) ($74)
15% ($233) ($122) ($12) $98 $208 15% ($83) ($75) ($66) ($58) ($49)
30% ($141) ($33) $76 $184 $292 30% ($41) ($37) ($33) ($28) ($24)
Policy: Option B - 20% Equity, 0 yr Duration mismatch Policy: Option C - 14% Equity, 0 yr Duration mismatch
-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%
-30% ($194) ($174) ($154) ($134) ($114) -30% ($174) ($156) ($138) ($120) ($102)
-15% ($160) ($144) ($127) ($110) ($94) -15% ($150) ($134) ($119) ($103) ($88)
0% ($126) ($113) ($100) ($87) ($74) 0% ($126) ($113) ($100) ($87) ($74)
15% ($92) ($82) ($73) ($64) ($54) 15% ($102) ($92) ($81) ($71) ($60)
30% ($58) ($52) ($46) ($40) ($34) 30% ($78) ($70) ($62) ($54) ($46)
Discount Rate Change (parallel shift) Discount Rate Change (parallel shift)
Equ
ity R
etur
n
Equ
ity R
etur
n
Policy Comparison: Sensitivity of Surplus/(Deficit) ($millions)
Discount Rate Change (parallel shift) Discount Rate Change (parallel shift)
Equ
ity R
etur
n
Equ
ity R
etur
n
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Selecting the risk budget Selecting the risk budget
Alternative investment policies
Funding ratio risk budget
Fun
ding
rat
io r
etur
n
Required
return
How much return does client need?
Minimize funding ratio risk for the given required return
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
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Implementation challengesImplementation challenges
• Aren’t interest rates too low to implement a liability hedge?
• we agree that interest rates are low, but they are not that low
• set up action plan to hedge liability as rates rise
• Liability hedging strategies reduce risk • Investment committee must measure investment
performance based on funding ratio, not against peers
• Client needs to feel comfortable with new types of risk when using interest rate derivatives
• counterparty • collateral and cash flow issues
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Example: Managing the risk budgetExample: Managing the risk budget
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
80% 85% 90% 95% 100%Funding ratio
(Termination basis)
Fundin
g rat
io risk
budget
Assumption: Plan frozen and goal is to terminate
A
B
C
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Example: Managing the risk budgetExample: Managing the risk budget
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
80% 85% 90% 95% 100% 105% 110%
Funding ratio
Fundin
g rat
io risk
budget
Assumption: Ongoing plan and goal is to avoid falling below 80% FR
C
B
A
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SummarySummary
• Understand liabilities• Liabilities are bond-like but they are not just bonds
• Develop and select risk budget• Hedge liabilities with long duration bonds + swap• Generate efficient absolute return• Select risk budget that balances funding ratio risk and
return objectives
• Implementation• Implementation of liability hedge can incorporate interest
rate views
• Managing the risk budget• Dynamically manage risk budget as a function of funding
ratio
Sponsors needs to develop and manage a funding ratio risk budget
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2006 Pensioners
SWAPS: An exchange of cash flowsSWAPS: An exchange of cash flows
Fixed benefit payments
Pension Fund Swap counter party
Receive fix
• Net payments are reduced when rates decline and therefore value of SWAP position is increased
• Result is that when rates go down, value of both the SWAP position and liability position increase
• The bigger the SWAP position the less impact interest rate movements will have on the funding ratio
Interest rate swaps can transform your fixed benefit payments into floating payments
Pay floating
For illustrative purposes only.
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Impact of duration mismatch on funding ratio
Impact of duration mismatch on funding ratio
• The value of the liabilities increases faster than the value of the assets do
Falling interest rates create a deficit
• The value of the liabilities decreases faster than the value of the assets do
Rising interest rates create a surplus
Assets
Liabilities
DeficitVa
lue
AssetsLiabilities
SurplusVa
lue
Currently, interest rate changes cause funding ratio changes
For illustrative purposes only.
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Impact of swap overlayImpact of swap overlay
• Funding level reduced: liabilities increase relative to assets
• Swap has a positive value which precisely offsets the reduction in funding level
Swap overlay immunizes funding ratio from interest rate changes
Falling interest rates: positive swap value
AssetsLiabilities
SwapV
alu
e
AssetsLiabilities
SwapVa
lue Rising interest rates: negative swap value
• Funding level increased: assets increase relative to liabilities
• Swap has a negative value which balances the funding level once again
Swaps reduce the impact of interest rate movements on funding ratio
For illustrative purposes only.
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Additional disclosures Additional disclosures Past performance is no guarantee of future results. There is no guarantee that investment objectives, risk or return targets discussed in this presentation will be achieved.
The opinions expressed in this presentation are those of the UBS Global Asset Management Business Group of UBS AG and are subject to change. No part of this presentation may be reproduced or redistributed in any form, or referred to in any publication, without express written permission of UBS Global Asset Management. This material supports the presentation(s) given on the specific date(s) noted. It is not intended to be read in isolation and may not provide a full explanation of all the topics that were presented and discussed.
Information contained in this presentation has been obtained from sources believed to be reliable, but not guaranteed. Furthermore, there can be no assurance that any trends described in this presentation will continue or that forecasts will occur because economic and market conditions change frequently.
The information contained in this presentation should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this information or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio over the course of a full market cycle.
It should not be assumed that any of the securities transactions or holdings referred to herein were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities referred to in this presentation.
A client's returns will be reduced by advisory fees and other expenses incurred by the client. Advisory fees are described in Part II of Form ADV for UBS Global Asset Management (Americas) Inc.
This presentation does not constitute an offer to sell or a solicitation to offer to buy any securities and nothing in this presentation shall limit or restrict the particular terms of any specific offering. Offers will be made only to qualified investors by means of a prospectus or confidential private placement memorandum providing information as to the specifics of the offering. No offer of any interest in any product will be made in any jurisdiction in which the offer, solicitation or sale is not permitted, or to any person to whom it is unlawful to make such offer, solicitation or sale.
Any statements made regarding investment performance expectations, risk and/or return targets shall not constitute a representation or warranty that such investment objectives or expectations will be achieved. The achievement of a targeted ex-ante tracking error does not imply the achievement of an equal ex-post tracking error or actual specified return. According to independent studies, ex-ante tracking error can underestimate realized risk (ex-post tracking error), particularly in times of above-average market volatility and increased momentum. Different models for the calculation of ex-ante tracking error may lead to different results. There is no guarantee that the models used provide the same results as other available models.
Copyright © 2006 UBS Global Asset Management (Americas) Inc.