Asset Allocation and the Use of Hedge Funds CFA Traveling Conferences June 2008

Asset Allocation and the Use of Hedge Funds Growth of the hedge fund industry and ramifications for return expectations Risk measurement and management of hedge funds Where hedge funds fit in a long-term portfolio strategy for high-net-worth investors

Hedge Funds Today? Hedge funds are risky and speculative investments that do not perform Increase in the numbers hedge funds will lead to erosion of returns The higher the Sharpe and the lowest the correlation, the better an alternative investment is

1. Capacity and Performance: Only Alpha? The reality of hedge fund returns: alpha and beta, inefficiencies and timing Does a simple regression capture properly an asset manager’s return? Isn’t alpha scarce and unstable? Future growth and capacity in the long run

Beta Is Increasing and Alpha Decreasing

Beta Exposure Movements in Different Market Environments Did not participate in the bear market Participates in the bull market Defensive mood looking forward. Therefore, less up participation today Recently Beta is decreasing Participation in the up market

Sources of Hedge Fund Performance RHedge Funds =  + Traditional + Alternatives Market inefficiencies -Beta Allocation Skill & Selection Skill Traditional Risk premium: Equity Risk Duration Risk Alternative Risk premium: Small Cap vs. Large Cap Implied Volatility (VIX) Credit Spread Systematic Behaviour It is not because a manager is exposed to traditional  or alternative  that he will perform, the manager’s skill matters

Infinity of Sources of Return Alpha is a small part of the returns (20%) Betas are liquid and readily available Skills matter A regression, a number, doesn’t capture behavior The beta discussion is hence a rhetorical one

Hedge Funds Are Mutants Example of recently developed non-scalable niches: Structured finance PIPE (private investment in public equities) CDO / CDS / abs / ABL Latin America Indian long short Example of recently developed scalable niches: Shareholder activism Quant strategies Natural resources / themes Distressed

3. Fitting hedge funds to private client portfolios Dual Benchmarks investors: Cash Minimum or Whatever goes up the most (especially if my friends have it) Hedge Funds will never compete with high performing long only assets Hedge Funds can help true diversification

Good use of HF Allocation Risk taking in alternative betas Bond Substitution Equity Substitution for conservative mandates Profitable and Sticky for bank (not!)

Probability of not reaching the target Target NAV after 3 years 128 Cash Bonds Buy & Hold Equity Buy & Hold Hedge Fund of Fund Probability of not reaching the target 100% 95% 47% 31% The Risk is one of NOT reaching a target in a time period

In the Long Run Hedge Funds Outperform Global Equities Fund of Hedge Funds Target Global Bonds Can you afford this? - 47.9% Drawdown 31 Months

Who Cares About the Long Run Dual Benchmark requires Dynamic Risk Taking in Long Only Asset Classes Further Risk Taking with Aggressive Alternative Beta providers (Credit, Distressed, Macro, High Vol Market Neutral) Risk Diversification (Vol Arb, Convertible Arbitrage, Stat Arb, Long Short Equity, Long Only Absolute Return)

Q&A

Appendix

Sources of Hedge Fund Performance RHedge Funds =  + Traditional Identification of Alpha & Beta components by EIM Hedge Fund performance is a function of Alpha and Beta Sources of Hedge Fund Performance + Alternatives RHedge Funds =  + Traditional

Identification of Alpha & Beta components by EIM Beta: The Framework Market Risk Exposure + Systematic Behaviour = Beta Can be either classified as Traditional or Alternative

Identification of Alpha & Beta components by EIM Beta: The Framework Market Risk Exposure + Systematic Behaviour Traditional: Long Only positions Ex: Long Equity Long AAA Bonds Traditional: Buy & Hold Alternative: Exposure to market involving Short Selling and/or Leverage. Ex: Long Value / Short Growth Credit Spread Alternative: Variable Optionality Long Optionality Short Optionality

Identification of Alpha & Beta components by EIM Examples of Traditional and Alternative Betas Investment Methodologies Equity / Buy & Hold Traditional Market Exposure + Traditional Behaviour Equity / Variable, Long or Short Optionality Traditional Market Exposure + Alternative Behaviour Equity Small vs Large / Buy & Hold Alternative Market Exposure + Traditional Behaviour Long Short Equity / Variable, Long or Short Optionality Alternative Market Exposure + Alternative Behaviour Traditional Market Exposure + Traditional Behaviour Private Equity / Buy & Hold

Identification of Alpha & Beta components by EIM Examples of Traditional and Alternative Betas Investment Methodologies Equity / Buy & Hold Traditional Beta Equity / Variable, Long or Short Optionality Alternative Beta Equity Small vs Large / Buy & Hold Alternative Beta Long Short Equity / Variable, Long or Short Optionality Alternative Beta Private Equity / Buy & Hold Traditional Beta

Identification of Alpha & Beta components by EIM The complexity and combination of different Betas is large Equity β, Fixed Income Duration, Credit Duration times Systematic Behaviour Buy & Hold = 3 Traditional Beta’s

Minimum 18 Alternative Risk Factors Minimum 18 Alternative Risk Factors times 4 Systematic Risk Control Behaviours = 72 Alternative Beta’s