Hedge FundsLecture 1: Overview

Ezra Zask

Yale University

September, 2005

Definition• Investment approach

– A sub-set of alternative investments that incorporate all investment strategies run with an orientation to producing primarily absolute returns using largely marketable securities.

– Strategies typically include short-selling and often include leverage– As a result, correlations with broader markets are expected to be modest to low.

• Legal Definition– Freedom from ICA (1940) controls on:

• Leverage• short-selling• cross-holding• 10% limits• incentive compensation• derivatives positions

– Limitations on:• number of U.S. investors (99 maximum)• solicitation of U.S. investors• public advertising and disclosure

Institutional Allocation

Allocation Methodology

Impediments to Investing

Institutional Assets

Institutional Share of Assets

Long Only Managers

Structured Products

Asset Class Allocation by Institutional Investors

Asset Class Percent Allocation

Equity 51%

Fixed Income 17%

Real Estate 4%

Hedge Funds 15%

Private Equity 3.2%

Venture Capital 3.5%

Natural Resources 3%

Source: NACUBO Endowment Study

Strategy Allocation

Strategy Assets ($bln) Percent Assets Number Funds

Long/Short Equity Hedge

282 35% 1148

Event Driven 38.6 18% 316

Other 40.7 9% 316

Fixed Income Arbitrage

38.6 166

Global Macro 32.6 8% 146

Emerging Markets 31.7 7% 168

Market Neutral 26.8 6% 212

Convertible Arbitrage

22.2 5% 124

Dedicated Short 1.2 -- 17

Source: Lipper/Tass

Hedge Fund Location

Location Percent Assets

Cayman Islands 35%

United States 32%

British Virgin Islands 8%

Bermuda 8%

Bahamas 4%

Luxembourg 3%

Asia 4%

S&P Hedge Fund Strategies

Strategy Definitions

Fixed Income Arbitrage

Convertible Arbitrage

Merger Arbitrage

Equity Market Neutral

Distressed Securities Strategy

Special Situations

Equity Long/Short

Managed Futures

Global Macro

Strategy PerformanceConve

rtible Arbitra

ge

Distressed

Securities

Emerging

Markets

Equity Hedge

Equity Market Neutra

l

Event-Driven

Fixed Incom

e Arbitra

ge

Fixed Incom

e Convt Bonds

Fund of

Funds

Macro Merger

Arbitrage

Market Ti

Relative

Value Arbitra

ge

Dec 1993 15.22 32.54 87.10 27.94 11.11 28.22 16.64 23.60 26.32 53.31 20.24 24.18 27.10

Dec 1994 -3.73 3.84 7.65 2.61 2.65 6.00 11.94 -0.62 -3.48 -4.30 8.88 3.49 4.00

Dec 1995 19.85 19.73 9.02 31.04 16.33 25.11 6.08 19.17 11.10 29.32 17.86 12.58 15.66

Dec 1996 14.56 20.77 35.69 21.75 14.20 24.84 11.89 18.24 14.39 9.32 16.61 13.47 14.49

Dec 1997 12.72 15.40 19.85 23.41 13.62 21.23 7.02 17.60 16.20 18.82 16.44 13.57 15.93

Dec 1998 7.77 -4.23 -36.39 15.98 8.30 1.70 -10.29 7.53 -5.11 6.19 7.23 24.82 2.81

Dec 1999 14.41 16.94 40.06 44.22 7.09 24.33 7.38 36.94 26.47 17.62 14.34 26.17 14.73

Dec 2000 14.50 2.78 -9.39 9.09 14.56 6.74 4.78 -11.17 4.07 1.97 18.04 11.79 14.43

Dec 2001 13.37 13.28 11.51 0.31 6.71 12.18 4.81 3.30 2.80 6.87 2.76 4.09 8.92

Dec 2002 9.07 5.28 -0.03 -4.71 0.98 -4.30 8.77 -13.07 1.01 7.42 -0.86 -3.26 5.42

Dec 2003 9.93 29.58 32.41 20.53 2.46 25.33 9.35 17.52 11.62 21.44 14.39 15.38 9.72

Dec 2004 0.97 18.21 16.92 7.66 4.63 14.23 5.15 8.60 6.39 4.72 3.51 3.68 5.03

Strategy Performance (2) Mean Return

(%)

Standard Deviation

(%)

Sharpe Ratio Skewness Kurtosis Alpha Beta

HFRI Convertible Arbitrage TR 10.53 6.56 1.6341 -1.1349 1.1389 0.0963 0.0863

HFRI Distressed Securities TR 14.02 10.99 1.3205 -0.0382 -0.5506 0.1193 0.2043

HFRI Emerging Markets Global TR 14.31 30.23 0.5911 0.6470 2.1399 0.1524 0.2087

HFRI Equity Hedge TR 15.86 14.27 1.1668 0.2938 -0.3562 0.0972 0.5501

HFRI Equity Market Neutral TR 8.43 5.32 1.6088 0.0563 -1.5066 0.0707 0.1172

HFRI Event-Driven TR 14.98 10.92 1.4171 -0.5234 -1.1254 0.1091 0.3615

HFRI Fixed Income Arbitrage TR 6.77 6.49 1.0732 -1.5944 4.7397 0.0770 -0.0587

HFRI Fixed Income Convt Bonds TR 9.74 14.52 0.7328 -0.1235 -0.1972 0.0369 0.5515

HFRI Fund of Funds TR 8.87 10.38 0.8976 0.4218 -0.6267 0.0671 0.2066

HFRI Macro TR 13.52 15.41 0.9337 1.5481 2.9839 0.1063 0.2987

HFRI Market Timing TR 12.14 9.36 1.3350 0.0168 -0.8327 0.0871 0.3003

HFRI Merger Arbitrage TR 11.41 7.04 1.6514 -0.5811 -1.1259 0.0908 0.2017

HFRI Relative Value Arbitrage TR 11.33 6.93 1.6616 0.7886 0.8755 0.1045 0.0847

Style Risk Return

Ris k (STD)

Return (A M)Ja nu a ry 1990 - Jun e 2005Risk vs. Return

2.0% 19.0%3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0%

-2.0%

16.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%

CSFB/Tremont Convertible A rbitrage Index

CSFB/Tremont Dedicated Short Bias Index

CSFB/Tremont Emerging Markets Index

CSFB/Tremont Equity Market Neutral Index

CSFB/Tremont Event Driven Index

CSFB/Tremont Fix ed Income A rbitrage Index

CSFB/Tremont Global Macro Index

CSFB/Tremont Long/Short Equity Index

CSFB/Tremont Managed Futures Index

CSFB/Tremont Hedge Fund Index

TA SS Fund of Funds Universe A verage

Style Correlations 1/1994-6/2005

Style Correlations

  Distressed EmergingMarkets

EquityMarketneutral Even Multi Fixed Income Macro HF Index Futures FoF

Distressed Index 1 0.5823 0.363 0.9357 0.7509 0.3117 0.3161 0.5796 -0.1267 0.661

Emerging Markets Index 0.5823 1 0.2464 0.6653 0.6665 0.2751 0.419 0.6535 -0.0991 0.7399

Equity Market Neutral Index 0.363 0.2464 1 0.3918 0.3658 0.1133 0.2098 0.3364 0.1231 0.4441

Event Driven Index 0.9357 0.6653 0.3918 1 0.9317 0.3881 0.3824 0.6691 -0.1741 0.7577

Multi-Strategy Index 0.7509 0.6665 0.3658 0.9317 1 0.4289 0.4279 0.6878 -0.1948 0.7616

Fixed Income Arbitrage Index 0.3117 0.2751 0.1133 0.3881 0.4289 1 0.4541 0.4476 -0.0685 0.426

Global Macro Index 0.3161 0.419 0.2098 0.3824 0.4279 0.4541 1 0.8587 0.2445 0.6453

Hedge Fund Index 0.5796 0.6535 0.3364 0.6691 0.6878 0.4476 0.8587 1 0.1264 0.9082

Managed Futures Index -0.1267 -0.0991 0.1231 -0.1741 -0.1948 -0.0685 0.2445 0.1264 1 0.1171

Fund of Funds 0.661 0.7399 0.4441 0.7577 0.7616 0.426 0.6453 0.9082 0.1171 1

CISDM Style Beta Analysis

  S&P 500 Small Cap S&P Volatility Implied VolChange in Implied

VolYield Curve

SlopeCredit Risk

Premium10 Year Swap

Spread

Equity Hedge M M M H M M H M

Relative Value Arbitrage M H H L M M H M

Global Macro M H M L M M M M

Fund of Funds M M M H M M H M

Equity Market Neutral M M M M M L M M

Convertible Arbitrage M H H L M L M H

Fixed Income: Arbitrage M M H L M H M M

Hedge Fund Alpha