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

2. 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

3. 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

4. 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

5. Beta Is Increasing and Alpha Decreasing

6. 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

7. 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

8. 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

9. 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

10. 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

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

12. 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

13. 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

14. 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)

15. Q&A

16. Appendix

17. 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

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

19. 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

20. 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

21. 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

22. 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

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