Absolute Return Strategies - Arrow Funds€¦ · among absolute return strategies. We plan to deliver 1940 Act products that make use of these differences. By doing so, we will provide

Absolute Return Strategies

TWST: Please start with an overview of Arrow

Funds. Tell us all about its investment philosophy and what

you do there.

Mr. Flaig: Arrow Funds is one of the fasting growing

investment management companies in the industry. The company

was formed in early 2006 and launched its first product, the

Arrow DWA Balanced Fund, in August of that year. We’ve had

great success with that product — it exceeded $100 million in

AUM right after its one-year anniversary. Over the last year, the

Fund has continued to outperform 90% of the funds in the Morn-

ingstar moderate asset allocation category.

Arrow’s vision is to manufacture and distribute alterna-

tive investment solutions for financial intermediaries and their

clients. The Arrow founders are made up of the original product

development team at Rydex Investments. They worked together

for a number of years as a team, developing and distributing mu-

tual funds, ETFs, variable trust funds and WRAP programs. The

business lines and products they created were instrumental com-

ponents to the recent sale of Rydex. I met this team when I was

the Director of Portfolio Management at Rydex. I joined Arrow

Funds earlier this year, in the capacity of Chief Investment Offi-

cer, with a mandate to enhance the firm’s manufacturing capabil-

ity of absolute return strategies and oversee other investment

initiatives. Absolute return strategies aim to produce positive re-

turns in as many environments as possible.

In a declining market, successfully implemented abso-

lute return strategies aspire to provide positive returns, or to avoid

or hedge market risk. To this end, absolute return strategies may

use hedging, short selling, or for arbitrage or other positions less

dependent on broad market direction. In a declining market, a

relative return strategy, which is designed to track an index, will

track the index down — the manager, who typically has a man-

date to stay invested, hopes to marginally outperform on the

downside. Conversely, in a rising market, the relative return man-

ager benefits from the rising tide of its asset class. The manager

may or may not participate in such a rise, depending on whether

William E. Flaig Jr., Chief Investment Officer at Arrow Investment Advisors, LLC, joined the firm in February

2007. He spent five years at Rydex Investments, working as Director of Portfolio Management, in which he managed

the entire portfolio team. While at Rydex, Mr. Flaig defined the concept of hedge fund replication, initiated the

research and investment strategies on which the Rydex Absolute Return Strategies Fund and the Rydex Hedge

Equity Fund are based, and directed those strategies. He also developed best practices for creating leverage within

the constraints of a mutual fund offering unlimited trading. Prior to Rydex, he spent six years at Bankers Trust

Company in a range of roles including currency trading, proprietary trading, derivatives structuring, emerging

market fixed-income, and currency trading. He graduated from Purdue University with a degree in Management.

M O N E Y M A N A G E R I N T E R V I E W

R E P R I N T E D F R O M N O V E M b E R 1 9 , 2 0 0 7

M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s

his strategy is correlated to or hedged against the rising asset

class, and whether or not the sources of the absolute return strat-

egy’s returns and risk are related to that asset class.

Absolute and relative returns are different from each

other and widely varied among themselves. Stock and bond

funds, while both relative return strategies, are as different from

each other as long/short equity are from fixed income arbitrage

among absolute return strategies. We plan to deliver 1940 Act

products that make use of these differences. By doing so, we will

provide mutual fund investors with an array of tools comparable

to that available to institutional investors. We would love to put

the mutual funds on a more equal footing with endowments by

providing similar product objectives and nontraditional sources

for returns, greater opportunities for diversification and tools for

risk management. Our first absolute return strategy vehicle is

called the Arrow Alternative Solutions Fund.

TWST: Tell us about some of these alternative invest-

ment strategies that you brought to the firm and how that ties

in with the Aternative Solutions Fund.

Mr. Flaig: I will speak to my background a little bit

before I go into that. Prior to working at Rydex, I had extensive

experience at Bankers Trust with investment strategies and assets

that ran the gamut from fixed income, equities, global fixed in-

come, and currencies to derivatives trading and structuring. This

helped me acquire insight and expertise into the instruments used

in alternative strategies. My experience at Rydex, which is pri-

marily an equity indexing shop that uses derivatives extensively,

afforded the opportunity to hone the practical application of these

instruments for mutual funds. As the Director of Portfolio at

Rydex, I was responsible for the management of $10 billion

spread over several unique investment strategies. I was signifi-

cantly involved in building and then refining the firm’s quantita-

tive investment process. Also, I extensively researched and

developed the concept and framework for Rydex’s hedge fund

replication strategies.

I left Rydex to research and develop a better alternative

value proposition. While the roots of my replication research

helped, I’ve spent the last 18 months developing another alterna-

tive approach. The Arrow Alternative Solution Fund is a major

step forward because it combines some of the principles of hedge

fund replication with modern portfolio theory. At Arrow, I’ve

developed several absolute return factors, which go beyond tradi-

tional investment methodologies because they attempt to reduce

correlation to the risk of a given asset class.

Whether or not to favor relative return factors or abso-

lute return factors, and how to apply those factors, are questions

strongly influenced by the efficient market debate. I believe that

the bulk of traditional returns are driven by exposure to relative

return factors. Because a relative return factor behaves with high

correlation to and within its asset class, it has no mechanism to

control downside risk during cyclical negative market periods.

Therefore, relative return factors contain market risk. Tradition-

ally, investors have attempted to mitigate the risk inherent in

relative return factors by creating diversified portfolios, which

may allocate between stocks and bonds, between domestic and

international stocks, between growth and value stocks, or be-

tween stocks of different capitalization ranges and different sec-

tors. I believe that the ultimate goal of diversification — to

combine assets that move independently of one another — has

not been satisfactorily achieved by traditional approaches. My

approach combines these absolute return factors to create a core

alternative portfolio. This kind of portfolio construction is opti-

mal for seeking absolute returns and capital appreciation with

low volatility and low correlation to the equity markets.

“The Fund’s principle investment strategy seeks to maximize returns from a diversified portfolio of three long and short strategies with a targeted risk objective. We are looking to achieve a total rate of return that meets or exceeds 10% per year after management fees over a rolling three- to five-year time horizon, with a risk target of 7% as measured by annual standard deviation, and a beta to the S&P 500 of less than 0.5.”


The Fund’s principle investment strategy seeks to maxi-

mize returns from a diversified portfolio of three long and short

strategies with a targeted risk objective. We are looking to

achieve a total rate of return that meets or exceeds 10% per year

after management fees over a rolling three- to five-year time ho-

rizon, with a risk target of 7% as measured by annual standard

deviation, and a beta to the S&P 500 of less than 0.5. As with any

fund, let me state that we do not represent or guarantee that the

Fund will meet these goals.

TWST: The Alternative Solutions Fund seems to

combine features of mutual funds and hedge funds. Is that

correct and, if so, what are the differences?

Mr. Flaig: You’re correct, the Fund does combine fea-

tures of mutual funds and hedge funds. The markets are a catalyst

for change and so is market regulation. The mutual fund industry

is always looking for way to preserve its own income stream as

well as investor capital. Their foray into the hedge fund space

started in 1997 when Congress repealed the mutual fund short-

short rule. Congress believed it would be in the public interest if

mutual funds could trade (and hedge) more broadly and effectively.

Rydex delivered the first inverse strategies that were tied to indices

like the S&P 500. These funds became great hedging tools for the

tactically proficient investor. Other manufacturers created dedi-

cated long/short strategies and now some are utilizing strategies

designed to mirror the performance of hedge fund indices.

More specifically, the Arrow Alternative Solutions Fund

is a mutual fund structure with hedge fund features. Hedge funds

have long been highly regarded for their use of alternative strategies

and investment techniques. However, the structure of the hedge

funds themselves often raises concerns for investors. Historically,

the mutual fund industry has been oriented to long-only investing.

This orientation has proven costly, especially since 1999. The fu-

ture demands a more varied investment approach in order to pre-

serve and enhance capital for a generation of investors.

The Arrow Alternative Solutions Fund seeks to combine

the best features of hedge funds and mutual funds. Some of the

shared characteristics compared would be that hedge funds and

long/short mutual funds are both seeking absolute returns — that

is, positive returns regardless of the market environment — while

traditional mutual funds are generally just seeking returns relative

to benchmarks that have periods of outperformance and underper-

formance. Traditional mutual funds typically have high correla-

tions to equity and bond markets while the Arrow Alternative

Solutions Fund and hedge funds have low correlations to equities

and the bond market. Mutual funds are highly regulated with over-

sight from the SEC, while hedge funds operate in an environment

with far less regulation. Mutual funds have restrictions on leverage,

illiquid securities, and derivatives; limitations on incentive fees;

and protective custody requirements. These restrictions keep some

of the problems found in the hedge fund away. Mutual funds are

highly transparent and they offer liquidity through the daily NAV.

Most hedge funds pride themselves on not being transparent and

they limit the frequency of investor redemptions. Another major

difference is the structure of managers’ compensation. Mutual

fund companies charge fees from 1% to 4.5% on the amount of

assets under management, regardless of performance (in the case

of the Arrow Alternative Solutions Fund, the fee is 1.52%). Most

hedge fund companies charge flat management fees of 1% to 2%

based on the total assets under management plus 20% to 25% in-

centive fees. Aside from the hedge funds’ high fees and lack of

oversight, the next biggest barriers to purchase are investor qualifi-

cations and high minimums.

“The Arrow Alternative Solutions Fund is a mutual fund structure with hedge fund features. Hedge funds have long been highly regarded for their use of alternate strategies and investment techniques. However, the structure of the hedge funds themselves often raises concerns for investors. Historically, the mutual fund industry has been oriented to long-only investing. This orientation has proven costly, especially since 1999. The future demands a more varied investment approach in order to preserve and enhance capital for a generation of investors.”


Hedge funds are restricted to accredited investors and

they typically have investment minimum that range between

$100,000 to $1,000,000. Mutual funds are open to all investors.

While most funds do have minimums, these minimums range

between $1,000 and $10,000. Our Fund’s non-qualified mini-

mum is $5,000 and $2,000 for retirement accounts.

Offering a more diversified and robust portfolio that can

preserve and enhance capital over time in all market environ-

ments is something that only a very few have had access to in the

past. The Arrow Alternative Solutions Fund was designed so that

all investors can have access to a low cost, highly diversified

absolute return strategy. It’s indeed the best of both worlds.

TWST: Tell us about the allocation of your different

strategies and the composition of the Fund?

Mr. Flaig: The Arrow Alternative Solutions Fund pro-

vides exposure to three long/short strategies, including hedged

equities, fixed income arbitrage and managed futures. The goal

of each long/short strategy is to systematically identify and pro-

vide exposure to absolute return factors on an ongoing basis. The

hedged equity strategy seeks to generate returns from investing

on both the long and short sides of equity markets while main-

taining a low correlation to the US equity market. The hedged

equity strategy will provide exposure to eight absolute return fac-

tors (e.g. long/short value). The Fund could have between 40%

and 60% exposure to this strategy.

The fixed income arbitrage strategy seeks to generate

returns from relationships between different fixed income securi-

ties, employing long and short positions to minimize exposure to

interest rate changes that are either mathematically or historically

interrelated. The strategy will provide exposure to five absolute

return factors (e.g. high yield credit spread). The Fund could have

between 20% and 45% exposure to this strategy.

The managed futures strategy seeks to generate returns

from convergent and divergent trends in the commodity, financial

and currency futures markets. The Fund could have between 20%

and 30% exposure to this strategy. The managed futures strategy

will provide exposure to four absolute return factors (e.g. long/

short commodity sector relative strength). The allocation among

the strategies is determined with a portfolio optimization tool to

maintain targeted risk of 7%.

The Fund has several long/short portfolios but there is

ultimately an underlying investment rationale that supports why

the absolute return factor has historically had positive perfor-

mance and why we would expect that performance to continue in

the future. I speak to this in a

white paper that we’ve devel-

oped, and each investment ratio-

nale is supported by industry

practice and academic research.

TWST: Do the three

long/short investment strate-

gies, your three buckets, all in-

clude the absolute return factors

you mentioned previously?

Absolute Return Factors for each Strategy

“The Alternative Solutions Fund provides exposure to three long/short strategies, including hedged equities, fixed income arbitrage and managed futures. The goal of each long/short strategy is to systematically identify and provide exposure to absolute return factors on an ongoing basis. The hedged equity strategy seeks to generate returns from investing on both the long and short sides of equity markets while maintaining a low correlation to the US equity market.”

M O N E Y M A N A G E R I N T E R V I E W ——————— I N V E s T I N G I N s T O c k s

Mr. Flaig: They do. Since absolute return factors are

being pioneered by Arrow Funds and it’s not a widely publicized

concept, I think it would be helpful to explain what they are.

Absolute return factors go beyond traditional invest-

ment methodologies in an attempt to reduce correlation to the

risk of their asset class. The objective is to deliver the return of

a particular investment style, while reducing that style’s overall

and market risk, thus reducing portfolio volatility over time.

We use a quantitative methodology to identify two subsets

within each absolute return factor: those assets expected to

outperform the asset class, which are held long; and, those ex-

pected to underperform the asset class, which are sold short.

This long/short portfolio construction attempts to minimize

the risk of substantial losses stemming from market declines

while reducing volatility.

Each absolute return factor is tied to a very common

hedge fund strategy. The long/short value is an absolute return

factor in the Fund’s hedged equity strategy. I use this as an illus-

tration because almost all investors have a value exposure in their

portfolio. Another very commonly held exposure in portfolios is

size. This is based on research done by many, but particularly

Fama and French, who validated the idea that value and small

companies historically outperformed the marketplace. The ratio-

nale for why they outperformed the overall market is that an in-

vestor is taking more risk in a value company or a small cap

company. The investor is compensated for this greater risk with a

greater return, so risk reward supports why investors, from an

academic standpoint, include value in their portfolios and why

investors include small cap in their portfolios.

Since the early 1990s, this has been a generally ac-

cepted investment philosophy and people have been allocating

to these styles accordingly. That’s the starting point for an ab-

solute return factor, but when an investor buys value or buys

small cap he is also just getting equity market risk or equity risk

premium as well in his investment. You will still have years

where even a value holding or a small cap holding will lose

money if the overall equity market is down. The return is al-

ways going to be relative to that equity risk premium and if you

look at the correlation to the S&P 500, value and size investing

is high—higher than 0.8 and very likely higher than 0.9. The

Fund’s long/short portfolio construction and the absolute return

factor philosophy are applied to a value basket. The absolute

return factor that provides exposure to value will buy value

stocks just like traditional investors but we simultaneously pur-

chase a portfolio of non-value stocks against the long basket.

What is produced is the absolute return of value and not

the relative return of value. By doing that, we are reducing the

equity exposure, emphasizing the value exposure in a more pure

way. This is the simple building block behind the Fund’s absolute

return factors.

This long/short portfolio construction is applied to

many of the same traditional investment styles that are used by

investors today. The Fund will be long a broad mix of finan-

cial asset classes, including equities, fixed income, currencies

and commodities. The Fund will be short the same broad mix

of financial asset classes using derivatives. Most long/short

strategies focus on one or multiple absolute return factors.

Some focus on just equities, fixed income or commodities.

The individual exposures are rarely combined. However,

hedge fund of funds strategies will combine them. How they

are combined is their downfall. Isolating those traditional in-

vestment styles into a corresponding absolute return factor is

critical to our approach. Our value proposition is how we com-

bine these factors.


“The managed futures strategy seeks to generate returns from convergent and divergent trends in the commodity, financial and currency futures markets. The Fund could have between 20% and 30% exposure to this strategy. The managed futures strategy will provide exposure to four absolute return factors (e.g. long/short commodity sector relative strength). The allocation among the strategies is determined with a portfolio optimization tool to maintain targeted risk of 7%.”

M O N E Y M A N A G E R I N T E R V I E W ——————— I N V E s T I N G I N s T O c k sM O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s

TWST: How are you able to get a performance re-

cord for such diverse strategies? What is the comparison you

use to measure performance?

Mr. Flaig: I spent the last 18 months testing each ab-

solute return factor. I have elaborated on this in a white paper.

In the paper, we use only third-party data to be able to test the

strategy both historically and transparently. Because of data

quality, we limited the overall backtest, but I have personally

tested equity absolute return back to 1927. There are obvious

data limitations on the fixed income and commodity data set for

our testing, but we backtested the Fund’s strategy with third-

party data back to 1995. Because there are practical limits that

come with third-party data, we produced our own proprietary

historical return stream for each absolute return factor. This

data set was created to help our implementation and manage-

ment of the Arrow Alternative Solutions Fund. We are also

happy to report that the conclusions were essentially the same

when we compared the two data sets.

What we’ve created is very exciting. The Arrow Alterna-

tive Strategy was tested back to 1995 has offered an annual return

of 14% with a risk of about 6%. This is an excellent risk-adjusted

return when compared to traditional assets. The beta to the S&P

500 over that time period was about a 0.13, and a .46 Sharpe ratio.

What was really telling was how the strategy performed over the

worst and best three year period since 2000. Between April 2000

and March 2003 the S&P 500 lost an annualized 16.1% with a

standard deviation of more than 17%. During that time period, the

alternative strategy was up about 13%, again, with a 6.3% standard

deviation. Between April 2003 and March 2006 the S&P 500 was

up 17% annualized with a standard deviation of 8.8%. During that

time period, the alternative strategy was close to 13%, again, with

a 6.5% standard deviation. While the S&P 500 was nearly flat over

the combined period, the Arrow Alternative Strategy annualized

return was more than 12% and less risk and very little correlation.

In an environment when the S&P 500 is doing very well or an

environment when the S&P 500 is doing poorly, this Fund’s back-

tested performance has been stable. We’ve seen strong returns with

a very controlled level of risk and a low beta to the S&P 500. So

from a big picture perspective, if you think of a portfolio as the

efficient frontier as we’ve all been taught, adding this strategy to a

portfolio bumps the efficient frontier out to what’s commonly

called the northwest quadrant: more return for either the same or

less risk to the positive attribute.

If you look at it

over a complete market

cycle, in years when tradi-

tional investments are

struggling, this strategy is

performing extremely well,

and in years when the S&P

or bonds are strong, this

strategy is also keeping up

— it’s still on the efficient

frontier. From the diversifi-

cation standpoint, you are

getting strong performance

and diversification in bear

markets, which is when you

need it most, and the cost of

doing it is minimal because

it’s still on the efficient

frontier in strong market

environments.

Historical Look at the Arrow Alternative Strategy


TWST: Are there any other risk management tech-

niques that you incorporate into the strategies that you can

tell us about?

Mr. Flaig: I would like to keep that simple. In our optimi-

zation approach, we are targeting a fixed level of risk as opposed to

an asset-based target. That’s an extremely strong value proposition.

We do have diversification constraints in place to prevent the Fund

from piling into one strategy at any given time. We also have the risk

constraint: for an absolute return strategy even to be considered in

the Fund, it has to have a compelling historical risk towards justifica-

tion supported by research beyond our own institution with a strong

enough investment rationale that would convince us that the strate-

gy’s compelling performance would continue in the future.

We have several additional risk controls that are inher-

ent to mutual funds themselves. Also, from a portfolio construc-

tion standpoint, think of the extent that a long/short strategy is

leveraged. We are buying long exposure that’s greater than the

Fund’s assets and we’re creating short exposure, which is also

significant. The level of that overall exposure is constrained so

that we can’t get runaway leverage and the amount of net expo-

sure, which is the long minus the short exposure, has to be below

0.8 as well. The Fund has to be long/short and not overly lever-

aged — these risk controls are laid out in the Fund’s prospectus.

As mentioned earlier, alternative strategies have posted

strong returns with lower volatility than their stock and bond coun-

terparts. But to round out that picture, it’s necessary to consider that

volatility is not the only measure of risk a client could face. Volatility

takes into account what normally happens, but it doesn’t reflect just

how far outside the normal distribution the returns can be. For that

we looked at the risk band — that is, the peak, median and low.

The alternative strategy does a satisfactory job of

achieving its 7% risk objective when we evaluated the rolling

three-year average from January 1995 though September 2007.

The risk band is narrower than the equity market and most of the

hedge fund proxies that we put it against. Looking at the 36-

month rolling standard deviation and return, we discovered what

you would expect for the S&P 500. The S&P 500 risk band

ranged between 7.6% and 22.2% with average risk of 16.7% and

average return of 10.9%. When compared to credit Suisse Trem-

ont Hedge Fund Index, the risk band was smaller — 3.1% to

12.9% — but it had lower average risk of 8.4% and slightly lower

returns of 10.3%. However, the risk band for the alternative strat-

egy was tighter and similar to a bond portfolio (between 6% and

7.6% with an average risk of 7.1% and a 13.3% return). This was

higher than both. The Credit Suisse Tremont Hedge Fund Index

performance was in line with our strategy but its risk band re-

sembled the equity markets — it had a beta of.50 and risk average

of 10.3%, similar to a traditional 60% equity and 40% bond port-

folio. The average beta for the alternative strategy was 0.16.

TWST: What gives this Alternative Solutions Fund its

edge? What are the defining features that you think makes it

distinctive compared with other al-

ternative strategies at other firms?

Mr. Flaig: The diversifi-

cation across multiple hedge fund

strategies and the specific risk tar-

get of 7% are competitive advan-

tages. The Fund is combining three

systematic long/short strategies is

also an advantage over black-box

type construction methodologies

used by others. Lastly, the fund is

not backward looking — that is,

looking at what hedge fund indexes

or hedge fund holdings have been.

It is only forward-looking in its

portfolio construction.


Risk Band for Various Market Indicators


If I compare those advantages to groups of other alterna-

tive products in the marketplace, the Arrow Alternative Solutions

Fund has better diversification and better risk controls than funds

that are offering hedge fund replication (that is, a high correlation

to hedge fund indexes); additionally, it is not a black box and is

not looking backward at hedge fund indexes.

When I look at this fund versus hedge funds of funds or

mutual funds that invest in hedge fund subaccounts, the Arrow

Alternative Solutions Fund has superior diversification and risk

controls. We also do not have manager risk or capacity con-

straints that might exist in some of those funds.

Many of those funds are allocating to small hedge fund

managers, a process that does not have scalability. This is be-

cause as hedge fund managers get bigger, their performance

tends to deteriorate. Not unlike in the mutual fund space, the

niche is somewhat dependent upon liquidity and small size to be

able to deliver that value proposition.

The Arrow Alternative Solutions Fund may not have

scalability problems, so it will not have limits as to how much it

can grow without a deterioration of performance. And lastly,

against long/short strategies that are proliferating in the market-

place, most of them are not diversified; they are actually nar-

rowly focused on a particular investment style. They don’t have

diversification, they have manager risks, and a lot them are focus-

ing on what I would call the, 120-20, 130-30 type of long/short

portfolio construction, which is very different from the portfolio

construction used in this Fund. You should note that a lot of these

funds struggled in the volatile market over the summer of 2007.

In 120-20 portfolio construction, the manager buys $1.20 of long

exposure for every dollar of investor money and creates the 0.2

short exposure. This structure gives the manager leverage to beat

a benchmark, but it does not lower portfolio’s correlation to the

S&P 500. The portfolio’s 120% long exposure minus 20% short

exposure has 100% net long exposure, which is why its correla-

tion to the S&P 500 is higher.

Our fund’s portfolio net exposure will not be 100% net

long. In fact, historically the strategy will have $1.50 of long ex-

posure and $1 of short exposure — 150% long exposure minus

100% short exposure has 50% net exposure. That is half of the

overall market exposure. The net exposure will range between

50% and 80%, which is driven by our optimization process.

Tools that provide lower correlation to the traditional equity mar-

ket are better vehicles to diversify traditional portfolios.

Most people don’t realize that risk in hedge funds and

active manager is driven by the parameter of the corresponding

manger’s opportunity to seek potentially higher returns and not

by the investor’s risk tolerance.

The risk-targeting concept can also be thought of as risk

rebalancing. Ultimately, an investor’s risk tolerance is fixed over

most time periods and likely decreases as he or she ages, holding

other variables constant. This is not in conjunction with what

most investors actually hold in their portfolios (an asset mix of

60/40, 40/60 etc.,), which varies widely over time.

The conventional asset allocation portfolio’s riskiness is

independent of the investor’s risk tolerance. Regardless of their

risk tolerance, investors are taking more risk when the market is

riskier and taking less risk when the market is less risky. With the

targeted risk approach I propose, the investor is conceptually

buying more of the relatively riskier assets during periods of low

overall risk and buying more of the least relatively risky assets

during periods of high overall risk.

TWST: Though this fund might not be suitable for

all investors, would you give us a description of your typical

clients who are interested in alternative strategies?

Mr. Flaig: A majority of our investors will be financial

intermediaries. Most of these intermediaries are turning to tacti-

cal and alternative strategies to increase diversification, boost

returns, and help manage risk. If the investor’s goal is to secure


Long / Short Portfolio Exposure


higher returns at a lower risk, then integrating the Arrow Alterna-

tive Solutions Fund into a traditional portfolio should help reduce

portfolio volatility and improve the odds of preserving capital

over the long term.

Allocation to alternative assets is a strategy that many

endowment managers (e.g. Harvard, Yale) are utilizing today.

Prior to 1999, Harvard’s investing was strictly limited to US

stocks, bonds and cash. They recognized they were taking on too

much risk and missed out on opportunities with alternative as-

sets. Since 1999 they gradually started to shift away from tradi-

tional assets toward “absolute return” assets. Today, Harvard

allocates 17% toward alternative assets and most endowments are

allocating between 10% and 25%. These asset classes have the

potential to deliver “equity-like” returns, but since they are not

correlated with US equities, they cushion the portfolio against

losses when the domestic stock market goes through its inevitable

down cycles.

One of our goals is to create value for our clients by offer-

ing investment strategies that seek to enhance returns and mitigate

risk. Our first product, The Arrow DWA Balanced Fund, tactically

provides exposure to four market segments (US equities, interna-

tional equities, fixed income and alternative assets). Our tactical

core is designed to be responsive to changing market conditions but

it is missing exposure to “absolute return” strategies. The Arrow

Alternative Solutions Fund enables clients to blend our tactical core

product with a fund with absolute return strategies to create their

own endowment solution for their clients.

We have selling agreements with more than 200 of the

top national, regional, independent broker/dealers and registered

investment advisor-based platforms. Currently, more than 500

financial intermediaries are using the Arrow DWA Balanced

Fund. We are focused on getting financial intermediaries to fol-

low the endowment path of adding “absolute return” assets to

their clients’ portfolios. We know that many of them are using

hedge funds and managed futures strategies for their high net

worth clients. The innovation of blending three alternative strate-

gies within a low-cost mutual fund wrapper allows many of our

clients to finally offer an “absolute return” strategy to investors

who normally don’t have access to this type of strategy.

TWST: Is there anything that you would like to add?

Mr. Flaig: Many of our clients ask us how much they

should move toward alternative strategies. We typically tell our

clients that the investor’s risk profile should dictate that. How-

ever, the risk band of some alternative strategies makes it difficult

to pin down a realistic allocation. Then we point the client toward

the endowment path. Most endowments have already identified

their allocations, which is critical for positioning their school as-

sets and budgets. Their portfolios need to participate in strong

upside markets while limiting their exposure to the downside. If

they fail, the school assets drop and their operating budget is re-

duced, resulting either in a possible increase in tuition or the need


Correlation of Alternative Asset

An investor should consider the Fund's investment objective, risks, charges, and expenses carefully before investing or sending

money. This and other information about Arrow Funds is contained in the fund's prospectus, which can be obtained by calling

1-877-277-6933. Please read the prospectus carefully before investing. Arrow Funds is distributed by Aquarius Fund Distributors.

1161-AFD-11/20/2007

The Arrow Alternative Solutions Fund may not be suitable for all investors. The fund’s use of derivatives such as futures, options

and swap agreements may expose the fund to additional risks that it would not be subject to if it invested directly in the securities

underlying those derivatives. Investing in leveraged instruments will magnify any gains or losses on those instruments. Investing in

commodity and currency related securities may be subject to greater volatility than investments in traditional securities. The fund's

use of short selling involves increased risks and additional costs. Investing in small-cap securities, may have special risks associated

including wider variations in earnings and business prospects than larger, more established companies. The Fund may invest in fixed

income securities, which are subject to risks including interest rate, credit and inflation. The maximum sales charge for Arrow’s

A-shares is 5.75%. A-share investors may be eligible for a reduction in sales charges. The Fund charges a fee of 1.00% on redemptions

of shares held less than 30 days. The Arrow DWA Balanced Fund’s annual operating expense is 2.01%. The Arrow Alternative

Solutions Fund’s annual operating expense is 1.52%.


to spend a portion of the endowment base during down markets.

Many advisors need to look at their clients’ portfolios in the same

light. There are 62 endowments funds that manage assets of more

than $1 billion. Collectively, these endowments manage more

than $229 billion and allocate 22.4% of their portfolios toward

absolute strategies. Since 2002, that allocation has increased 26%

during a very strong equity market.

Many of our clients also ask us what component of the

portfolio should be reduced. Most optimizers will reduce the

riskier assets like equities. My advice would be to follow what the

smart money is doing. The 62 endowments that we mentioned

earlier have reduced their fixed income exposure by 39% since

2002. It makes sense. During the last three-year bear market

(April 2000 to March 2003), the S&P 500 was down 16.1% a

year while bonds were up 9.8%. Our alternative strategy, which

we will use as a proxy for absolute returns, was up 12.9%. Since

1999, the strongest three-year period for the S&P 500 was from

April 2003 to March 2006. During that period, the S&P 500 was

up 17.2% a year but bonds were only up 2.9%. Absolute return

strategies are designed to respond in all market conditions. While

bonds provided the support during down markets, it typically does

not participate equally when the markets are strong. Our alterna-

tive strategy over the same bull market period was up 12.7% a

year. That is why endowments have reduced their fixed income

exposure and maintained the same equity exposure since 2002.

Absolute return strategies are typically not correlated to

the movement of traditional assets. The beauty of the Arrow Al-

ternative Solutions Fund is that it combines strategies that do not

exhibit a high correlation to one another, potentially giving the

investor an opportunity to reduce risk without sacrificing returns.

We believe that in order to realize the benefit of diversification, a

portfolio’s underlying asset classes must behave differently in

varying market conditions. If the investor’s goal is to secure

higher returns at a lower risk, integrating alternatives into a tra-

ditional portfolio should help reduce portfolio volatility and im-

prove the odds of preserving capital over the long term. This is

the value proposition of the Arrow Alternative Solutions Fund.

TWST: Thank you.

Note: Opinions and recommendations are as of November 1, 2007.


© 2007 The Wall Street Transcript, 48 West 37th Street, NYC 10018Tel: (212) 952-7400 • Fax: (212) 668-9842 • Website: www.twst.com

Definitions

Volatility is a measure of fluctuations in value based on annualized standard deviation of monthly returns. Beta is a measure of

relative risk. Correlation is similarity in performance to the equity markets. Sharpe Ratio measures risk-adjusted returns by taking the

return less the risk-free rate, and dividing the result by the standard deviation. Absolute returns are generally positive rerturns in any

market environment.

Footnotes

The Arrow Alternative Strategy reflects hypothetical or simulated performance figures and is not meant to represent actual performance

results for the Arrow Alternative Solutions Fund. Past performance is not indicative of future results. Potential for profit is accompanied

by possibility of loss. These figures reflect a simulated portfolio managed with the Arrow Alternative Strategy using actual &

hypothetical performance data for various financial instruments based on Arrow Investment Advisors analysis. The simulated model was

constructed using their proprietary set of rules for the purchase and sale of securities for each underling strategy as outlined in the Arrow

Alternative Solutions Fund prospectus. There can be no assurance that actual transactions would have given the same results, although

the manager believes results of actual trades would have been very similar. Performance results reflect the re-investment of dividends

and other earnings. The performance results are net transaction costs and operating expenses associated with the management of the

Arrow Alternative Strategy. The performance of the Hypothetical Arrow Alternative Strategy was reduced by 252 bps annually.

Performance displayed represents past performance, which is no guarantee of future results. The information provided here is

for informational purposes only, is not intended as investment advice and should not be construed as a recommendation with regard to

investment decisions. Source for charts and graphs: Morningstar, Bloomberg, Deutsche Bank calculated by Arrow Investment Advisor,

LLC. The index returns assumes re-investment of all dividends but do not reflect any management fees, transaction costs or expenses.

The indices are unmanaged and are not available for direct investment. The Strategy benchmark comparison returns are comprised

of three Credit Suisse / Tremont hedge Fund Indices: 33.3% Long Short equity, 33.3% Fixed Income Arbitrage and 33.3% Managed

Futures indices. The Credit Suisse/ Tremont hedge Fund Indices are the asset-weighted benchmarks of hedge fund performance.

It is not possible to invest in indexes which are unmanaged and do not incur fees and charges. The 60% equities and 40% bonds is

comprised of S&P 500 and Lehman Aggregate Bond Index. The S&P Index is the Standard & Poor’s Composite Index of 500 stocks

and is a widely recognized, unmanaged index of common stock prices. The Lehman Brothers U.S. Aggregate Bond Index is an

unmanaged index composed of investment-grade securities from the Lehman Brothers Government/Credit Bond Index, Mortgage-

Backed Securities Index, and Asset-Backed Securities Index.

Documents

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