Introduction to: Hedge Funds and Fund of Hedge Funds

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Introduction to:Hedge Funds and Fund of Hedge FundsAugust 2005

by

Pension Consulting Alliance, Inc

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Introduction

Characteristics and Attributes

Performance and Volatility

Program Design

Discussion of Hedge Funds

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In 1949, Alfred Jones established the first hedge fund in the US.

hedged against the likelihood of a declining market.

based on the premise that performance depends more on stock selection than market direction

utilized two speculative tools to implement his strategy: short selling and leverage

used leverage to obtain profits, but employed short selling through baskets of stocks to control risk

Today, a “hedge fund” is much more broadly defined

compensated primarily on the fund’s performance

seek superior returns relative to risk by utilizing a broad spectrum of investment styles, hedging strategies and financial instruments that have low or no market risk

do not have to be registered with the Securities Exchange Commission (SEC)

not be advertised or offered to the general public

Discussion of Hedge FundsIntroduction

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Hedge funds are not an asset class

is a type or style of asset management

– normally skill based not homogenous (not many common factors)

Hedge funds are commonly considered alternative investments because they:

are privately structured and limited to “sophisticated” investors

can contain significant financial leverage and contain other risk factors– financial leverage (use of margin accounts and short-term loans)– instrument leverage (use of derivatives that magnify returns)

span a broad array of high risk strategies, producing highly volatile returns

exhibit return behaviors that can be independent from other asset classes


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Arguments of hedge fund investing

Pros:

– low correlation to other major asset classes

– potential for high returns

– claim ability to add value throughout market cycles

Cons:

– high dispersion of returns

– lack of transparency

– concerns of fraud

– highly unregulated

– higher fee structures


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Characteristics:

Not publicly-traded

Investment returns do not behave like public market counterparts

Eclectic strategies

Less transparency

Discontinuous valuation processes

Loss of management control of investment capital

Very high fees / costs of management

Roles:

Achieve higher investment returns than publicly-trade assets due to illiquidity

Markets are large and private: choppy information flow leads to exploitable inefficiencies / potential to add significant value

Secondary role: incremental diversification

Discussion of Hedge FundsCharacteristics and Attributes

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Lack of disclosure

regulators require that hedge funds do not promote their services

– result: an unclear picture of industry performance

hedge funds disclose only limited amounts of investment data

– fund’s current investors have incomplete knowledge fund investments

summary: hedge fund managers compelled to withhold information

however, activities are increasingly becoming subject to regulation

There is a huge amount of survivorship bias in the industry

it is estimated that 20% of hedge funds fail each year

survivorship bias skews industry performance statistics


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Higher costs

commonly 2% management fee with a 20% performance fee

fund-of-funds commonly add an addition 1% management fee and a 10% performance fee

Lower liquidity, commonly:

quarterly or semi-annual redemptions with restrictions

one-year “lock-up”

however, more liquid than other alternative investments (i.e. private equity, real estate, etc.)

in addition, monthly subscriptions provide greater flexibility

Range of performance targets

absolute return targets (i.e., 10%-20% per year)

relative return targets (i.e., T-Bills + 5% over a market cycle)

Spectrum of investment strategies and approaches


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Hedge Funds

Typically limited partnership ranging from $10 million to $5 billion

Limited partners typically make one-time capital contribution

After “lock up” period, limited partners can access capital

Very wide array of strategies, including taking short positions

May invest in both public and private vehicles

General partners compensated by ongoing fee plus proportion of profits


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Hedge funds have exhibited significant growth

estimates vary significantly

from approximately 300 funds in 1990 to more than 7,000 today

– some estimate up to 8,000

estimated to be near $900 billion in capital, before leverage

pace of commitments to hedge funds continues to accelerate

Concern: too many assets flowing into management style/approach

Capital Allocated to Hedge Funds

0

100

200

300

400

500

600

700

800

900

1000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Q32004

$ B

illio

ns


Source: Hedge Fund Research, Inc.

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Manager styles can be organized by market exposure

Source: UBS Warburg, “In Search of Alpha”


Hedge Fund Styles

Relative Value Event-Driven Opportunistic

Convertible arbitrage

Fixed income arbitrage

Equity market neutral

Risk arbitrage

Distressed securities

Macro

Long region industry or style

Emerging markets

Long/short equity

Short sellers

Market ExposureLow High

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Strategies Definition Relative Value Convertible Arbitrage Invests in the convertible securities of a company. A typical investment is to be long the convertible bond and short the

common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of the stock, while protecting the principal from market moves.

Fixed Income Arbitrage Fixed income arbitrage managers seek to exploit pricing anomalies within and across global fixed income markets and their derivatives, using leverage to enhance returns. In most cases, fixed income arbitrageurs take offsetting long and short positions in similar fixed income securities that are mathematically, fundamentally or historically interrelated. The relationship can be temporarily distorted by market events, investor preferences, exogenous shocks to supply or demand, or structural features of the fixed income market.

Equity Market Neutral Equity market-neutral is designed to produce consistent returns with very low volatility and correlation in a variety of market environments. The investment strategy is designed to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to be either beta or currency-neutral or both. Equity market-neutral is best defined as either statistical arbitrage or equity long/short with zero exposure to the market.

Event Driven Risk Arbitrage Risk arbitrage (also known as merger arbitrage) specialists invest simultaneously in long and short positions in both companies

involved in a merger or acquisition. In stock swap mergers, risk arbitrageurs are typically long the stock of the company being acquired and short the stock of the acquiring company. In the case of a cash tender offer, the risk arbitrageur is seeking to capture the difference between the tender price and the price at which the target company’s stock is trading.

Distressed Securities Distressed securities funds invest in the debt or equity of companies experiencing financial or operational difficulties or trade claims of companies that are in financial distress, typically in bankruptcy. These securities generally trade at substantial discounts to par value. Hedge fund managers can invest in a range of instruments from secured debt to common stock. The strategy exploits the fact that many investors are unable to hold below investment grade securities.

Opportunistic Macro Macro hedge funds pursue a base strategy such as equity long/short or futures trend following to which large scale and highly

leveraged directional bets in other markets are added a few times each year. They move from opportunity to opportunity, from trend to trend, from strategy to strategy.

Short Sellers The short selling discipline has an equity as well as fixed income component. Short sellers seek to profit from a decline in the value of stocks. In addition, the short seller earns interest on the cash proceeds from the short sale of stock.

Long Region, Industry, or Style

Traditional equity fund structured like a hedge fund; ie, uses leverage and permits managers to collect an incentive fee. Focus of the fund could be a specific geographic region (i.e., Japan) , industry (i.e., technology) or style (i.e., growth)

Emerging Markets Emerging market hedge funds focus on equity or fixed income investing in emerging markets as opposed to developed markets. This style is usually more volatile not only because emerging markets are more volatile than developed markets, but because most emerging markets allow for only limited short selling and do not offer a viable futures contract to control risk. The lack of opportunities to control risk suggests that hedge funds in emerging markets have a strong long bias.

Long/Short Equity Long/short strategies combine both long as well as short equity positions. The short positions have three purposes, which can vary over time or by manager. First, the short positions are intended to generate alpha. This is one of the main differences when compared with traditional long-only managers. Stock selection skill can result in doubling the alpha. A long/short equity manager can add value by buying winners as well as selling losers. Second, the short positions can serve the purpose of hedging market risk. Third, the manager earns interest on the short as he collects the short rebate.


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Breakout of Hedge Fund Industry by Major Strategy Type

Long/Short34%

Event Driven19%

Global Macro10%

Convertible Arb.6%

Market Neutral5%

Fixed Inc. Arb.7%

Other10%

Em. Mkts.4%

Mng. Futrs.5%

By Assets(as of 12/31/04)

Market dominated by Long/Short, Event Driven and Global Macro


Source: TASS Asset Flows – January 1994-December 2004

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There are several risks unique to hedge funds: disclosure risk (i.e. lack of transparency)

partnership mortality risk (average life of partnership - 3 yrs.)

financial leverage risk (mitigated to some degree by ERISA)

return dispersion risk

Other risks: event risk

– correlations tend to increase during global shocks

manager selection risk

– more critical with hedge funds than anywhere else

complexity risks (of process, of transactions, of securities)

personnel risks (hedge funds are usually run by smaller firms)

asset growth (too large an asset base threatens nimbleness)

liquidity risk

fraud risk

Fund of funds manage these risks

Discussion of Hedge Fund of FundsSummary of Characteristics and Attributes

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At first blush, hedge fund strategy returns appear compelling…

…however, several key nuances must be taken into account

performance not an asset class, but a universe – issue: significant survivorship bias

Cumulative Returns: Stocks, Bonds, and Hedge Fund-of-Funds

0.8

1.3

1.8

2.3

2.8

3.3

3.8

4.3

Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05

Gro

wth

of

$1

CSFB/Tremont Hedge Fund Index LB Agg S&P 500

Notes:

Stocks: S&P 500, Bonds: Lehman Aggregate, Hedge Fund of Funds: CSFB/Tremont Hedge Fund Index.

Sources: CSFB/Tremont, ITI.

Discussion of Hedge FundsPerformance and Volatility

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Source: Altvest, CSFB/Tremont, Hennessee

Return vs Risk(latest 3 Years ending 12/31/04)

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%

Annual Standard Deviation

Ann

ual R

etur

n

Market Neutral

Macro

Emerging Mkts

Short Biased

Distressed Only

Opportunistic

Convertible Arb.

Merger Arb.

Strategies have a spectrum of risk and return characteristics

difficult period for short biased strategies


LB Aggregate

MSCI EAFE

S&P 500

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-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%


Ann

ual R

etur

n

Market Neutral

Macro

Emerging Mkts

Short Biased

Distressed Only

Opportunistic

Convertible Arb.

Merger Arb.

Significant improvement for short biased strategies

reflective of market cycle

LB Aggregate

S&P 500

MSCI EAFE

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Dispersion of Returns - Actual Dispersion of Managers

Source: Altvest, Nelsons, PCA

45.8

29.9

16.6

36.9

68.9

27.7

15.1

39.6

120.1

26.4

-4.5

-18.1

0.0

-8.9

-53.5

-0.9-5.3-20.1

-54.2

-11.9

-80

-60

-40

-20

0

20

40

60

80

100

120

140

MarketNeutralFunds

Long/ShortFunds

Macro Funds MergerArbitrage

US EquityManagers

MarketNeutralFunds

Long/ShortFunds

Macro Funds MergerArbitrage

US EquityManagers

One Year Five Years

Dispersion of Manager Returns Comparison - Periods ending 12/31/04(selected Hedge Fund categories)

Dispersion of hedge manager returns often greater than equity managers

Market neutral manager returns widely dispersed

notion of “consistent alpha” not evident

Merger arbitrage managers most consistent, long/short managers least consistent

Significant survivorship bias evident

Universe Participants55


31109 4151 30800 6894821011

An

nu

aliz

ed R

etu

rns

(%)

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Hedge fund-of-funds provide:

manager selection and monitoring

portfolio construction

– customized, strategy-oriented, blind pool

risk management

diversification

– combining various strategies can result in a desired spectrum of risk/return options

Additional layer of fees

commonly 1% management fee and 10% incentive fee

– in excess of underlying managers’ fees

highly dependent upon return objective

Limited liquidity

Limited transparency

Discussion of Hedge FundsHedge Fund-of-Funds

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0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%


Ann

ual R

etur

n

Discussion of Hedge Fund of FundsPerformance and Volatility

Fund-of-funds exhibit attractive risk/return characteristics


Market Neutral

Macro

Emerging Mkts

Short Biased

Distressed Only

Opportunistic

Convertible Arb.

Merger Arb. Directional Fund-of-Funds

Event Driven Fund-of-FundsRelative Value Fund-of-Funds

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Dispersion of Returns - Actual Dispersion of Fund-of-Funds

Source: Altvest, PCA

25.6 19.613.1

50.0

22.925.6

0.0

-8.1

4.6-5.3-3.1-2.1

-80

-60

-40

-20

0

20

40

60

80

100

120

Relative Value Event Driven Directional Relative Value Event Driven Directional

One Year Five Years

Dispersion of Fund-of-Fund Returns Comparison - Periods ending 12/31/04(selected Hedge Fund categories)

Dispersion across hedge fund-of-funds still significant

however, lower than most single-strategy funds

fund-of-funds selection still critical

Strategy specific fund-of-funds exhibit lower dispersion

Universe Participants360 1955 157152 69

An

nu

aliz

ed R

etu

rns

(%)


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significant dispersion among fund of funds

there is potential of missing return objectives by a material margin

– defining return objectives and manager selection is critical

Annual Dispersion of Fund of Hedge Fund Returns

84.2 81.3

116.1

51.1

18.6

128.9130.4

58.7

43.852.3

64.971.572.6

60.4

30.0

-14.9-13.9

-30.3-28.1-19.1

-61.8

-13.1

-45.5-40.3

-2.1-9.15.9

-6.0-0.1-2.7

-100

-50

0

50

100

150

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Sources: Altvest, PCA

Dispersion of Returns – Calendar Year ResultsA

nn

ual

Ret

urn

s (%

)


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Three general approaches:

include as a segment of an existing asset class :

– commonly a segment of the Alternative Investment asset class

adds consistency and some liquidity to otherwise privately-held strategies

– also could replace equities, fixed income, cash, etc

– depending upon targeted risk and return objectives

treat as a new asset class:

– allocation has to be material to have impact

– allocation level typically relies on optimization techniques

– key role is largely as diversifier versus other asset classes

– strategies with higher return objectives have higher exposure to underlying asset classes (i.e., more “directional”)

an alpha “overlay” to existing asset classes

– must be material to have impact within overall asset class portfolio

– utilizes significant amount of highly liquid derivatives to obtain market exposure

– assumption of “zero beta” to underlying asset class returns

Implementation ApproachesProgram Design

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At least 10% of Alternative Investments

large enough to be worth the cost/effort and impact results

If funded out of Alternative Investment segment hedge fund of funds could take capital from higher-return / higher-risk strategies

commitments to future private equity opportunities could decline

alternatively, hedge fund of funds could be used as “holding place” for future commitments

Requires enhancement to private equity portion of policies / guidelines

key function is providing liquidity; will also act as return stabilizer

absolute return objective

manager guidelines

Utilize either hedge funds or fund of hedge funds

depending upon resources, objectives and diversification needs

Implementation- Segment Approach Program Design

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Determine allocation to absolute return strategies during asset allocation / asset-liability review

Allocation at least 5%, possibly more

of sufficient size to impact results

dependent upon assumptions utilized in optimization process

Requires establishment of appropriate policy documents / guidelines

asset class definitions, parameters, and benchmarks

absolute return objective

manager guidelines



Implementation– New Asset Class ApproachProgram Design

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Concept: attaching added value that is uncorrelated to an asset class to an existing passive asset class portfolio

takes advantage of higher information ratios in absolute return areas

passive asset class portfolio is likely to be a combination of cash and futures

Caveats:

creating synthetic passive portfolios is not costless

alpha may, in fact, be correlated to asset class(es)

Areas of application:

publicly-traded asset classes (heavy depth/breadth of futures markets)



Implementation– Portable Alpha ApproachProgram Design

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0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Plan Assets

Establish Portable Alpha program to achieve an excess return at Total Portfolio level

Portable Alpha Program Portable Alpha Program

90% invested in Hedge funds

10% provides 100% of market exposure via Futures

200bp to 300bp excess over cash return

asset class return

Domestic Publicly-traded

Assets

Private Assets

International Publicly-traded Assets

MORE COSTLY TO HEDGE

TOO COSTLY TO HEDGE

ASSETS USED

ALLOCATION of ASSETS USED

Implementation– Portable Alpha ApproachProgram Design

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Implementation– Hedge Fund of Fund SelectionProgram Design

$1,531 domestic publicly-traded

assets

Next steps across all strategic options: Manager Selection and Portfolio Construction

Up to 8,000 hedge fund managers

600 – 800 hedge fund of fund providers

Due diligence effort analogous to private equity asset class

On average, the typical hedge fund of fund contains more than one dozen individual hedge funds

– multiple managers with complementary strategies may be combined

Hedge fund of fund costs are significant: “2 & 20” at fund level + “1 & 10” at fund of fund level

Depending on option: different structures, different objectives, different funds

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Manager selection and monitoring is crucial

due diligence and monitoring of managers should cover, at a minimum:

– people and organization

– investment strategy

– investment selection process

– portfolio construction process

– risk management procedures

– valuation guidelines and procedures

– investment terms


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Rationale for outsourcing hedge fund management (i.e. fund of hedge funds)

risk management

expertise

cost/resource requirements

diversification

one or more fund-of-fund could be utilized

– varied by strategy and manager


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Program construction a function of various factors

risk./return objectives

– low risk/return vs. high risk/return

– directional vs. non-directional

available resources

– Internally managed vs externally outsourced

– hedge funds vs. fund of hedge funds

diversification targets

– number of managers

– exposure across investment strategies

Implementation– Program ConstructionProgram Design

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Variety of investment strategies

not homogeneous

differing risk profiles and return spectrums

Multiple approaches to implementation

can incorporate into different segments of the Portfolio

– dependent upon return objectives and risk tolerances

Program construction dependent upon specific needs

requires significant resources to source, research, and monitor investments

a function of the selected implementation approach

Discussion of Hedge FundsConclusions

Documents

Introduction to: Hedge Funds and Fund of Hedge Funds