Caesar Lack, economist, caesar.lack@ubs.com, UBS AG Dirk Effenberger, strategist, dirk.effenberger@ubs.com, UBS AG Michael Nagel, economist, michael-za.nagel@ubs.

com, UBS AG Thomas Flury, strategist, thomas.flury@ubs.com, UBS AG

Wealth Management Research

18 August 2010

Investing in Switzerland
Special edition: Swiss assets for foreigners
s By incorporating Swiss franc investments, foreign investors can

diversify their portfolio and hedge against political and economic turbulence.
s For foreigners, the appreciation of the Swiss franc has largely made up

Further analyses: s "Investing in Switzerland", monthly publication from UBS WMR

s "You can benefit from "Swissness", July 29,

for the low interest rates in Switzerland in the last 30 years.

s We recommend that foreign investors include Swiss investments in

2010, UBS WMR

s "Switzerland - creditor in a debt crisis", May 21,

their strategic asset allocation. Due to the strength of the Swiss franc, however, it is recommended that only risk-averse investors looking to hedge their portfolio against currency or debt crises get on board at present. Attractive Swiss investments The financial center of Switzerland is associated in the minds of many foreign investors with anonymous numbered accounts, discreet back rooms and tight-lipped bankers with peculiar accents. Such associations may put foreign investors off Swiss investments. Other foreign investors steer clear of Swiss investments because the Swiss financial market is relatively small compared with financial markets in other countries. Below, we demonstrate that Swiss investments (equities, government bonds and deposits) have in the past offered international investors an attractive opportunity to diversify international investors have been able to benefit both from diversifying their portfolios with Swiss investments, mostly without lower returns, and from the insurance offered by the Swiss franc. A significant portion of the resulting returns were due to the upward trend of the Swiss franc. There are still strategic reasons (continuing diversification and insurance) for incorporating a good portion of Swiss investments in foreign currency portfolios. Due to the high value of the Swiss franc, it may, however, be worth biding one's time before purchasing for tactical reasons.

2010, UBS WMR

Figure 1. Exchange rates

1.1 1.0 0.9 0.8 0.7 0.6 1975 7 6 5 4 3 2 1 0 1980 1985 1990 1995 2000 2005 2010 USDCHF (right scale) GBPCHF (right scale)

DEMCHF

Source: Reuters Ecowin, UBS WMR. Since the introduction of the euro, DEM/ CHF has been calculated on the basis of EUR/CHF.

This report has been prepared by UBS AG.

Please see important disclaimers and disclosures that begin on page 6.

Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

UBS Wealth Management Research

18 August 2010

Investing in Switzerland

Factors determining the return of Swiss investments For foreign investors, returns from Swiss franc investments are made up of two components: the nominal return in Swiss francs and exchange rate performance. Nominal return in Swiss francs can in turn be subdivided into a real return plus compensation for inflation. Compared with the rest of the world, Switzerland has reported a relatively low rise in consumer prices over the last few decades, comparable only with Germany. Both real interest rates and inflation have in the past been lower in Switzerland than abroad. Low inflation and low real interest rates explain the low nominal interest rates compared with the rest of the world (Figure 2). Interest rate bonus and safe haven Since the world wars, real interest rates on the Swiss franc have been lower than real interest rates on other currencies. The phenomenon of low real interest rates in Switzerland is known as the "interest rate bonus". The low real interest rates are a "bonus" for debtors in particular - for investors, though, low real returns are a drawback. In the inflationary eighties, the difference in real interest rates was still several percentage points, but since then it has fallen significantly. The interest rate bonus is the flip side of the so-called "safe haven" offered by the Swiss franc: The Swiss franc is considered a safe haven which appreciates in times of crisis (Figure 3). For such insurance, investors may be prepared to accept lower interest rates. The reason for the interest rate bonus or the safe haven function is not least the confidence that investors have in Switzerland and the Swiss franc, which is based on Switzerland's monetary, political and social stability. Thanks to the safe haven function, incorporating Swiss franc investments lends a foreign currency portfolio a degree of protection against political and economic crises. The question now arises as to how much a foreign investor has to pay for this insurance or, in other words, whether and to what extent a foreign investor has to accept a lower return through diversification in Swiss investments. Returns of Swiss investments for foreigners An analysis of the returns of Swiss investments for German, British and US investors from January 1981 up to the present shows Swiss investments to have been surprisingly attractive. Figures 4, 5 and 6 illustrate the accumulated excess returns of an investment in the Swiss equity market, in Swiss federal bonds and in Swiss deposits, converted into the German mark or euro, British pound and US dollar, compared with a similar investment in the domestic market. Amazingly, between 1981 and the present, Swiss equities and federal bonds gave foreign investors significantly better returns on average than similar domestic investments. In the case of British and US securities, the appreciation of the Swiss franc more than makes up for the by and large lower returns of Swiss investments. German investors benefit both from the better performance of Swiss equities and the appreciation of the Swiss franc.

Figure 2. Interest on ten-year government bonds in %

18 16 14 12 10 8 6 4 2 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Switzerland Germany UK USA
Source: Reuters Ecowin, UBS WMR

Figure 3. Safe-haven appreciation of the Swiss franc Value of the Swiss franc, measured against the euro or deutschmark, indexed
112 110 108 106 104 102 days after event 100 0 5 9/11 10 15 20 25 30 35 40 45 50

Lehman Brothers

Invasion Kuwait

Source: Reuters Ecowin, UBS WMR

Figure 4. Excess returns of Swiss investments compared with German investments Accumulated, since Jan 1981
100% 80% 60% 40% 20% 0% -20% -40% -60% 1981

1985

1989

1993

1997

2001

2005 deposits

2009

equities
Source: Reuters Ecowin, UBS WMR

fixed income

Investing in Switzerland - 2

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18 August 2010

Investing in Switzerland

Investments in Swiss equities are interesting not only on account of their returns, but also on account of their diversifying effect. The monthly returns of a portfolio consisting of 90% German, British or US equities and 10% Swiss equities show less fluctuation for all three currencies than those of equity portfolios invested 100% in the domestic market (Table 1). Diversification using Swiss francs only proves less advantageous in the case of deposits. The Swiss francs deposits of German, US and British investors brought them lower returns in the local currency because the increasingly strong Swiss franc did not make up for the lower interest rates. Incorporating ten percent Swiss franc deposits also led to greater fluctuation in the value of portfolios due to currency fluctuations. Appreciation of the Swiss franc and date of entry Exchange rate developments have so far played a decisive role in investment performance. In the long term, the upward trend in the value of the Swiss franc has largely compensated for low nominal Swiss franc returns for various asset classes over the last thirty years, but getting on board at the wrong time can lead to long phases of relatively weak performance. Anyone, for example, who invested in Swiss investments when the Swiss franc was at its peak in 1996 had to wait for years before the Swiss investment, valued in a foreign currency, overtook the domestic market. We can illustrate the importance of the date of entry by simulating a strategy whereby a foreign investor invested only in Swiss investments when the Swiss franc was undervalued by at least one standard deviation compared with the domestic currency measured on the basis of purchasing power parity (PPP). We can compare this strategy with a strategy whereby a foreign investor invested only in Swiss investments when the Swiss franc was overvalued by at least one standard deviation, measured on the basis of PPP. Table 2 shows the average annual excess returns achieved using this strategy in the past (1981 to 2004) (compared with a similar investment in the domestic market) for a holding period of five years.

Figure 5. Excess returns of Swiss investments compared with British investments Accumulated, since Jan 1981
100% 75% 50% 25% 0% -25% -50% 1981

1985

1989

1993

1997

2001

2005 deposits

2009

equities
Source: Reuters Ecowin, UBS WMR

fixed Income

Figure 6. Excess returns of Swiss investments compared with US investments Accumulated, since Jan 1981
80% 60% 40% 20% 0% -20% -40% -60% 1981

1985

1989

1993

1997

2001

2005 deposits

2009

equities
Source: Reuters Ecowin, UBS WMR

fixed income

We calculate equity returns on the basis of the performance of the MSCI Total Return Index in the respective country. We approximate returns from bonds on the basis of an internally designed total return index for government bonds with five-year constant maturities. For deposit returns, we use the rates for three-month time deposits.

Table 1. Return (annualized) and risk (standard deviation of monthly returns) of Swiss investments for German/British/ American investors, 1981 to 2010
Measured in CHF equities fixed income deposits German investor German 90/10 Swiss asset asset Portfolio UK investor Swiss asset UK asset 90/10 Portfolio Swiss asset US investor US asset 90/10 Portfolio

10.1% / 4.8% 11.1% / 4.8% 9.6% / 6.2% 9.9% / 5.9% 14.0% / 5.1% 11.7% / 4.7% 12.1% / 4.6% 12.1% / 5.3% 10.6% / 4.5% 10.8% / 4.4% 2.5% / 0.1% 3.6% / 0.2% 3.4% / 1.3% 3.4% / 0.2% 3.4% / 0.2% 4.5% / 1.3% 4.9% / 0.2% 4.9% / 0.2% 6.2% / 2.9% 7.2% / 2.9% 4.1% / 0.3% 7.7% / 0.3% 4.3% / 0.4% 7.7% / 0.4% 4.5% / 3.5% 5.7% / 3.5% 3.7% / 0.3% 5.9% / 0.3% 3.9% / 0.4% 5.9% / 0.4%

Table 2. Average annual excess return of investments in the Swiss market at a time of massive over/undervaluation of the Swiss franc (measured on the basis of purchasing power parity) for a subsequent holding period of 5 years, 1981 to 2004
Buy equities at undervalued CHF German investor UK investor US investor 4.5% 1.4% 5.5% Buy equities at overvalued CHF -0.9% 0.0% -5.0% Buy fixed income at undervalued CHF 0.0% 0.9% 6.4% Buy fixed income at overvalued CHF -0.8% -4.0% -6.6% Buy deposits at undervalued CHF -0.4% -1.9% 5.1% Buy deposits at overvalued CHF -1.9% -7.0% -8.7%

Investing in Switzerland - 3

UBS Wealth Management Research

18 August 2010

Investing in Switzerland

For practically all investments and all currency pairs, diversification using Swiss franc investments at a time when the Swiss franc was overvalued led to massive underperformance compared with an investment in the domestic market. This is due to the fact that exchange rates always tend to even out again in the long term after large fluctuations. Hence, an investment in an overvalued currency usually leads to significant opportunity costs in the long term. Conversely, an investment in a significantly undervalued currency will in the long term usually be rewarded with substantial revaluation gains. The Swiss franc has seen significant appreciation since the beginning of 2008 and is currently (EUR/CHF 1.35; USD/CHF 1.05; GBP/CHF 1.64) overvalued by 9% against the euro (2.1 standard deviations), by 17% against the British pound (1.7 standard deviations) and by 12% against the US dollar (0.6 standard deviations) measured on the basis of PPP. For European investors, the Swiss franc is therefore significantly overvalued, which could have a negative effect on the performance of Swiss franc investments in the long term from a European perspective. Swiss francs interesting for risk-averse investors despite overvaluation A point in favor of the Swiss franc for risk-averse investors despite its overvaluation is the safe haven function it offers. Against the backdrop of increasing fears about the solvency of government debtors, Switzerland's sound financing is a strong trump card. When it comes to government debt, Switzerland is a model pupil it even managed to reduce its debt levels during the latest crisis (Figure 7). Switzerland is one of the few countries that was not living beyond its means in the run-up to the crisis. Hence, as a net creditor country, in the current debt crisis it is in a significantly better position than most other Western industrial countries which have high debt levels. Switzerland has the highest net foreign assets worldwide both per capita and as a percentage of gross domestic product (Figure 8). The counterparty risk of Swiss investments may not be zero, but we believe it is lower than the risk for the majority of other such investments. In this sense, many investments in Swiss francs, particularly those of government issuers, are comparable with gold the ultimate safe haven free of counterparty risk. In contrast to gold, which has gone up in price in recent years, the insurance offered by the Swiss franc still seems relatively reasonably priced to us. Conclusions By incorporating Swiss franc investments, foreign investors can diversify their portfolio and insure themselves against political and economic turbulence. The price that foreign investors had to pay in the past for this was negligible to non-existent due to the upward trend of the Swiss franc, equities in Swiss francs generated favorable additional returns for all three groups of investors, as did Swiss franc bonds for US investors and British investors, and also reduced fluctuations in the value of investments in equities. The picture is only negative for deposits. The appreciation of the Swiss franc was not able to make up for the lower interest rates. Moreover, the results are largely dependent on the timing getting on board at a time when the Swiss franc is overvalued noticeably reduces the returns that can be achieved.

Figure 7. Gross government debt ratio in % of GDP

150 125 100 75 50 25 1990

1995 Switzerland UK

2000 Germany Italy

2005 France USA

2010

Sources: Reuters Ecowin, OECD Economic Outlook, UBS WMR

Figure 8. Net foreign assets in % of GDP

150% 125% 100% 75% 50% 25% 0%

Singapore

Belgium

China

Argentina

Luxembourg

Sources: Reuters Ecowin, IMF, UBS WMR

Investing in Switzerland - 4

Netherlands

Switzerland

Germany

Japan

Norway

UBS Wealth Management Research

18 August 2010

Investing in Switzerland

The Swiss franc may well continue to serve as insurance in the future. Against the background of increasing uncertainty about the solvency of government debtors, by and large solidly financed Swiss companies and issuers may continue to become increasingly attractive. The exchange rate interventions carried out from March 2009 to avoid the strengthening of the Swiss franc (and hence to stop the Swiss franc from being overused as a safe haven) had to be halted in June 2010. The Swiss National Bank will find it more difficult to intervene in the future in the event of a safe-haveninduced appreciation due to its inflated balance sheet. We generally recommend that foreign investors include Swiss franc investments in their strategic asset allocation. By way of comparison, the equity market capitalization of the Swiss equity market totals 3% of MSCI World and, at that level, is on a par with Germany's, corresponding to around 40% of British equity market capitalization and around 7% of US equity market capitalization. According to the Bank for International Settlements, 0.7% of all outstanding bonds are denominated in Swiss francs. Due to the current strength of the Swiss franc, it is nevertheless recommended that long-term investors get on board only under certain conditions. The Swiss franc has appreciated considerably since the beginning of 2008. This makes the insurance offered by the Swiss franc more expensive and reduces the returns to be expected in the long term for foreigners. We recommend that risk-averse investors looking to insure their portfolio against currency or debt crises or other uncertainties with Swiss investments take advantage of periods when the Swiss franc is weak to build up Swiss franc positions. The strong Swiss economy and the interest rate hikes we expect as a result mean that the Swiss franc has the potential to appreciate even further in a twelve-month timeframe we expect EUR/ CHF to reach 1.30 and USD/CHF 0.96. For investments in the equity market in particular, the time could still be right to get on board on the one hand, exchange rate fluctuations have little effect on equity market investments; on the other hand, investors can take advantage of sustainable earnings growth on the Swiss equity market. Literature Kugler, Peter and Beatrice Weder (2002). "The Puzzle of the Swiss Interest Rate Island: Stylized Facts and a New Interpretation", HWWA discussion paper 168. Kugler, Peter and Beatrice Weder (2004). "International Portfolio Holdings and Swiss Franc Asset Returns", WWZ discussion paper 04/04. Kugler, Peter and Beatrice Weder (2005). "Why are Returns on Swiss Assets so low?", University of Basel.

Investing in Switzerland - 5

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18 August 2010

Investing in Switzerland

Appendix
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Investing in Switzerland - 6