Alternative Investment Strategies

Sponsored by:

Fact or Myth

• Volatility = Risk?• Diversification provides superior long-term

returns?• All investment opportunities normalize and

revert to the mean?

Is There a Hedge Fund Bubble?

• A trillion dollar industry - a world of 1,000 niches

• Multiple client agendas• Performance oriented culture• Market forces separate the wheat from the

chaff

• Understanding the payoff process and drivers• Forecasting the nominal dollar amount of the payoffs• Measuring the meaning, significance or utility of the payoffs

Long

Debt

Hybrids

Equity

Derivatives

Other

Short Hedged Arbitraged Other The space of opportunities for value investing has expanded enormously and the need for and the availability of flexibility has increased.

Structures

Co

rpo

rate

Ass

et C

lass

es

1

2Value investing emphasizes fundamental analysis of the payoffs from investment opportunities. We divide the analysis of payoffs into three key areas.

Combining Discipline with Flexibility in Value Investing

PricingModels

Return Models

DecisionModels

The toolbox and WAP approach (words, algebra and pictures) facilitates reframing by using decision analysis as the basic “power tool” and the other tools and concepts as “attachments”.

4 Game Theory

Options

The technique of framing and reframing is at the core of the analytic process for dealing with payoffs because it provides flexibility within the discipline of value investing.

Buffett’s bond/company analogy:•stock " company " bond " stock

– or –•bond " company " stock " bond

3

Combining Discipline with Flexibility in Value Investing

5 The wheel is a circular decision tree which puts all the above in the larger context of events and decisions affecting a value investor’s efforts to construct a portfolio based on asset allocation, security selection and structuring strategies

• Value investing as an investment philosophy and strategy emphasizes the return of money over the return on money. • Practitioners of value investing seek to earn at least reasonable returns during “normal” times, preserve principal during disruptive periods, and put money to work during such disruptive periods which ultimately earns abnormal returns. • If money is not lost, the cadence of normal and abnormal returns over time takes advantage of the power of compounding (which Albert Einstein supposedly said was one of the most significant forces in the Universe).

• Effective value investing combines the discipline and commitment of a coherent investment philosophy and strategy with the flexibility of reframing. • Buffett performs reframing, for example, with his bond/company analogy although he does not call it as such.• A conceptual tool box and the WAP approach (words, algebra and pictures) can facilitate reframing and provide multiple perspectives for analyzing the basic components of investment opportunities: understanding the payoff process and drivers, forecasting the nominal dollar amount of the payoffs, and measuring the significance, meaning, or utility of the payoffs.

• Accounting based valuation and the continuing value driver formulation can be used to reframe like Buffett by seeing a stock as partial ownership of a company and then as a bond and then back to a stock.• Another example of reframing is Professor Greenwald's approach of segmenting pricing models to reflect a company's competitive advantage and franchise.• We can compare this segmentation of the company's intrinsic price or value with the segments of the company's capital structure.• The value segments can then be matched with the capital structure segments to help clarify the bet an investor is making.

Customers

The FirmProducts and Input Markets

Capital Markets

Suppliers

Net Operating

Assets(NOA)

Net Financial

Assets(NFA)

Debtholdersor

Debt Issuers

Shareholders

All Stocks and Flows for a FirmNet operating assets employed in operations generate operating revenue (by selling goods and services to customers) and incur operating expenses (by buying inputs from suppliers).

OperatingActivities

FinancingActivities

OR - OE = OIOI - ∆NOA = C - I

C - I - ∆NFA + NFI = d

F = Net cash flow to debtholders and issuersd = Net cash flow to shareholdersC = Cash flow from operationsI = Cash investmentNFA = Net financial assets

NOA = Net operating assetsOR = Operating revenueOE = Operating expensesOI = Operating incomeNFI = Net financial income

Key:

(∆ indicates change)

OE

OR

C

I

F

d

Penman Analytical Framework for Accruals

Customers

The FirmProducts and Input Markets

Capital Markets

Suppliers

Net Operating

Assets(NOA)

Net Financial

Assets(NFA)

Debtholdersor

Debt Issuers

Shareholders

All Stocks and Flows for a FirmNet operating assets employed in operations generate operating revenue (by selling goods and services to customers) and incur operating expenses (by buying inputs from suppliers).

OperatingActivities

FinancingActivities

OR - OE = OIOI - ∆NOA = C - I

C - I - ∆NFA + NFI = d

F = Net cash flow to debtholders and issuersd = Net cash flow to shareholdersC = Cash flow from operationsI = Cash investmentNFA = Net financial assets

NOA = Net operating assetsOR = Operating revenueOE = Operating expensesOI = Operating incomeNFI = Net financial income

Key:

(∆ indicates change)

OE

OR

C

I

F

d

Penman Analytical Framework for Accruals

“Operating” and “Financing” Activities – All Stocks and Flows

Operating Activities

• (C - I) = OI - ∆NOA– operations generate operating income and free cash flow is

the part that remains after reinvesting some of it in net operating assets

– if investment in NOA > OI, free cash flow is negative– if investment in NOA < OI, free cash flow is positiveFinancing Activities

• (C - I) = ∆NFA - NFI + d OR (C - I) = NFE - ∆NFO + d – explains the disposition of free cash flow from operating

activities (above), i.e. free cash flow and net financial income(expense) increase (decrease) net financial assets (obligations) and increase (decrease) payout of net dividends

• CV = (NOPLAT (1-g / ROIC)) / (WACC – g)

• NOPLAT = OI = 177• ROIC = RNOA = OI / NOA = 177 / 1,325 = 13.3%• Assume WACC = 10% and g = 3%• CV = (177 (1 – 0.03/0.133)) / (0.10 – 0.03) = 1,958• Equity value = CV – NFO = 1,958 – 300 = 1,658

• (NOPLAT (1-g / ROIC)) = NOPLAT – NOPLAT (g/ROIC) = OI - ∆NOA

• ∆NOA represents the amount of OI (or NOPLAT) required to invest back into the business in order to achieve the assumed growth rate of OI (or NOPLAT)

• In this case, ∆NOA = 177 (0.03/0.133) = 40 vs. actual ∆NOA = 70• Need to analyze changes in OA and OL items to better understand economic and

growth opportunities (if ∆NOA applied to projects where ROIC > WACC, firm creates additional value and vice versa)

• Dupont analysis can yield insight into value drivers and wealth creation (destruction)

Continuing Value (McKinsey) Model for Valuing Equity

(2) NOPLAT = Net operating profit less adjusted taxes

(2)

DuPont Analysis - Break-down of Value Drivers

Level 1

Earnings = Comprehensive incomeCSE = Common shareholders’ equityOI = Operating income (after tax)NOA = Net operating assetsNFE = Net financial expenseNFO = Net financial obligations

ROCE = Earnings/CSE= RNOA + (FLEV x SPREAD)

NFOCSE

SPREAD = RNOA - NBC

RNOA = OI/NOA= ROOA + (OLLEV x OLSPREAD)

FLEV =

NFENFO

NBC =RNOA

PM = OI/Sales

Sales PM Other items PM

Gross marginratios

Expense ratios Other OI/Sales ratios

Individual asset and liability turnovers

Borrowing cost drivers

ROCE = Return on common equityRNOA = Return on net operating assetsROOA = Return on operating assetsNBC = Net borrowing costsOLLEV = Operating liability leverageOLSPREAD = Operating liability leverage spreadFLEV = Financial leverageSPREAD = Operating spreadPM = Operating profit marginATO = Asset turnover

Financialstatementline items:

Ratios:

Level 3

Level 2 ATO = Sales/NOA

(1) Adapted from Penman, Financial Statement Analysis and Security Valuation, 2nd Edition, 2004

Level 1

Earnings = Comprehensive incomeCSE = Common shareholders’ equityOI = Operating income (after tax)NOA = Net operating assetsNFE = Net financial expenseNFO = Net financial obligations

ROCE = Earnings/CSE= RNOA + (FLEV x SPREAD)

NFOCSE

SPREAD = RNOA - NBC

RNOA = OI/NOA= ROOA + (OLLEV x OLSPREAD)

FLEV =

NFENFO

NBC =RNOA

PM = OI/Sales

Sales PM Other items PM

Gross marginratios

Expense ratios Other OI/Sales ratios

Individual asset and liability turnovers

Borrowing cost drivers

ROCE = Return on common equityRNOA = Return on net operating assetsROOA = Return on operating assetsNBC = Net borrowing costsOLLEV = Operating liability leverageOLSPREAD = Operating liability leverage spreadFLEV = Financial leverageSPREAD = Operating spreadPM = Operating profit marginATO = Asset turnover

Financialstatementline items:

Ratios:

Level 3

Level 2 ATO = Sales/NOA

(1) Adapted from Penman, Financial Statement Analysis and Security Valuation, 2nd Edition, 2004

Correlation of Returns by Strategy1994-2005

0.13

0.28

0.21

0.45

0.45

Bond Arb.

0.68

0.18

0.66

0.66

0.37

0.39

Event Driven

0.3

0.21

0.35

0.33

0.21

0.08

0.36

Mkt. Neut.

0.42

-0.02

0.59

0.65

0.41

0.29

0.67

0.22

Emerg. Mkts

0.39

0.17

0.78

All

0.13

0.12

0.42

0.86

Global Macro

0.31Global Macro

0.31Bond Arb.

0.94Event Driven

0.57All

0.33Mkt. Neutral

0.58Long/Short

0.59Emerg. Mkts

0.51

0.16

Long/ Short

0.06

Multi strategy

0.56Risk Arb.

0.12Multi strategy

Distress.

200420022000199819961994

300

250

200

150

100

50

Index, 1994=100

All DistressedEmerging Mkts Event Driven

Hedge Fund Returns by Strategy

200420022000199819961994

300

250

200

150

100

50

Index, 1994=100

Risk Arb Global MacroLong/Short Equity Mkt Neutral

Hedge Fund Returns by Strategy

Correlation of Strategies with Broad Hedge Index Returns

20032001199919971995

1.0

0.7

0.5

0.2

-0.0

-0.3

18 month rolling correlation

Risk Arb Global Macro Long/Short

20032001199919971995

1.0

0.7

0.4

0.0

-0.3

-0.6

18 month rolling correlation

Bond Arb Distressed Emerg. Mkts

Correlation of Strategies with Broad Hedge Index Returns

Why Invest in Hedge Funds• Absolute Performance - Hedge Funds attempt to produce

consistent absolute returns regardless of the market direction. • Focus on Risk Management - Hedge Fund Managers focus on

preserving capital by carefully managing investment risks.• Hedge Fund Managers often heavily invested in their own

funds• Greater Diversification - Funds of Hedge Funds add a further

dimension of risk management, investor discipline and access to a diversified portfolio.

• Lower Volatility - The combined focus on absolute performance, risk management and diversification lead to a low volatility of performance.

Comparative Risk Adjusted Returns(January 1990-February 2005)

MSCI World Index

S&P 500

Hedge Funds

HY BondsLehman Agg. Bond Index

Gov't Bonds1-5Yr

90 Day T-Bill

0%

4%

8%

12%

16%

0% 2% 4% 6% 8% 10% 12% 14% 16%Risk (Standard Deviation)

Annualized Return

Historical Hedge Fund Performance (1990- Feb 2005)

20042002200019981996199419921990

8

6

4

2

0

Jan 1990 = 1

Lehman Brothers Agg. Bond Index

Hedge Fund Composite S&P 500

Historically, Hedge Funds have Outperformed both Equity and Bond Indices.

Long/Short Equity

Emerging Mkts

S&P 500

MSCI World Index

Distressed Securities

Event Driven

Hedge Fund Composite

Relative Value

Convertible Arb

Merger Arb

Equity Market Neutral

Fixed Income Arb

Lehman Agg. Bond

0%

4%

8%

12%

16%

20%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%Risk (Standard Deviation)

Composite Risk Adjusted Performance Risk vs. Reward Analysis of Hedge Fund Strategies (1990-2005)

Annualized Return

Historical Hedge Fund Asset Growth

20042000199819951990

1200

1000

800

600

400

200

0

US$ Billions

1000

600

350

190

50

Looming Risks to Fixed Income

• Rising interest rates – Telegraphed by the Fed

• Increasing default rates – Default rates abnormally low last 4 years

• Undue pressure to chase yield – Spreads are the lowest in modern history

Impact of Losses on Overall Return

$800,922.68 -11.88%$1,134,225.00 6.50%2001

$908,900.00 -9.11%$1,065,000.00 6.50%2000

$623,918.77 -22.10%$1,207,949.63 6.50%2002

$1,000,000.00 $1,000,000.00

$1,459,142.30

$1,370,086.66

$1,286,466.35

Value of Investment

S&P 500Hypothetical Fixed Return

63.88%

10.88%

28.70%

Annual Return

$1,459,142.30 6.50%2005

$890,348.05 6.50%2004

$802,983.45 6.50%2003

Value of Investment

Annual Return

The Importance of Protecting the Downside

Demonstrated Impact of Alternative Investments

22

6

1516 18

9

19

1114

7

20

1014

9

17

11 1115

2824

37

4245

48

9

0

10

20

30

40

50

60

Hedge Funds Venture Capital Private Equity Energy &Natural

Resources

Private/PublicEquity Real

Estate

FY 2000

FY 2001

FY 2002

FY 2003

FY 2004

Alternative Strategies Asset Mix Trends for Endowments

Percent

23

41 4250 50 47

13

1520

21 24 29

17

1514

13 10 8

9

23

129

5 419 15 12 9 7 4

5

23

2 5

3

0%

20%

40%

60%

80%

100%

> $1B $500M - $1B $100M -$500M

$50M -$100M

$10M - $50M $0M - $10M

Dom. Equities Fixed Income Intl. Equities

Short Term Securities/Cash Alternatives Hedge Funds

Allocations by Asset Classes

17.8

7.8 12

.2

10.1

37.6

16.8

11.7

7.2 12

.2

4.7

22.9

14.7

11.5

7.1 11

.0

4.2

0

10

20

30

40

50

DomesticEquities

DomesticBonds

AbsoluteReturn

ForeignEquities

PrivateEquities

Real Assets 10 YearPerformance

Yale ReturnsActive BenchmarkPassive Benchmark

Yale Performance Relative to Benchmarks (10 Years)

Active Benchmarks:Domestic Equity: Frank Russell Median Manager, U.S. EquityFixed income: Frank Russell Median Manager, Fixed IncomeAbsolute Return: CSFB CompositeForeign Equity: Frank Russell Median Manager Composite, Foreign EquityPrivate Equity: Cambridge Associates CompositeReal Assets: NCREIF and Cambridge Associates Composite

Passive Benchmarks:Domestic Equity: Wilshire 5000Fixed income: Lehman Brothers U.S. Treasury IndexAbsolute Return: 1-year Constant Maturity Treasure +6%Foreign Equity: 50% MSCI EAFE Index, 50% MSCI EM IndexPrivate Equity: University Inflation +10%Real Assets: University Inflation +6%

$<1B

–12

.5

$100

M -

500M

–8.

9

Yal

e R

etu

rns

–16

.8

4.6% CAGR Difference Between Domestic Bonds and Absolute Performance.

Asset Allocations

3.53.2Cash18.86.3Real Estates14.55.5Private Equity14.815.6Foreign Equity26.115.1Absolute Return7.417.5Fixed Income

14.836.8Domestic Equity

Yale University

(%)

Educational Institutions

(%)

Sources of Hedge Funds’ $66 billion of Institutional Money – 2003 Q4

Other7%

Private Plans22%

Endowments and

Foundations53%

Public Plans18%

Institutional Investors’ Top Concerns About Hedge Funds

Fees13%

Transparency15%

Headline risk38%

Impact of capital flows on returns

34%

Institutional Investors’ Views on Impact of Capital Flows on Returns

No impact24%

Significantly negative

43%

Slightly negative

33%

What is a Hedge Fund?

• The term "hedge fund" is not formally defined by federal securities laws

• The term usually refers to an investment entity that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act.

The Origin of Hedge Funds

• The first hedge funds appeared in the 1950s, and were characteristically long/short equity funds that engaged in fundamental hedging strategies.

Investors in Hedge Funds

• Hedge funds generally sell interests in private offerings to “accredited investors.”

• Accredited investors are individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth and most institutions with $5 million in assets.

Likely Impact of Registration of Hedge Fund Advisors

• If hedge fund advisers were compelled to register under the Advisors Act– The SEC would be authorized to collect

information about the activities of hedge fund advisers and hedge funds,

– It would increase the minimum investment requirement for direct investments as registered advisers are generally prohibited from charging performance fees unless investors have $750,000 invested with the adviser or have a net worth of $1.5 million.

Hedge Fund Index 10 Yr Returns

Global Macro Distressed Long/Short Equity

Event Driven CSFB/Tremont Hedge Index

15.0

14.0

13.0

12.0

11.0

% Annualized Return (93-04)

5.0

4.5

4.0

3.5

3.0

2.5

% Annualized Std. Dev.

Hedge Fund Index 10 Yr Volatility

Equity MktNeutral

Risk Arb. Multi-Strat.

Convert.Arb.

Fixed Inc.Arb

0.55

0.50

0.45

0.40

0.35

0.30

0.25

0.20

0.15

Beta

Hedge Fund Indices Beta

Emerg.Mkts

CSFB/ Tremont

Hedge Index

Distressed Event Driven

Long/ShortEquity

2.2

2.0

1.8

1.6

1.4

1.2

1.0

Sharpe Ratio

Hedge Fund Indices Sharpe Ratio

Equity Mkt. Neutral

Convt. Arb.

MultiStrat.

Event Driven

Distressed

Flattening Yield Curve

20Y10Y7Y5Y3Y2Y1Y6M3M1M

6

5

4

3

2

1

0

Percent

March 31, 2004

September 30, 2004

March 31, 2005

Examples of Hedge Fund Trades• Long/Short Equity - Preserving Gains:

– Stock A is owned at $5.00 a share and the shares increase in value to $15.00 per share, the fund can preserve its gains and limit its losses by selling the shares and purchasing calls at $17.00 for $2.00. The Fund has therefore locked in an $8.00 profit and limited it’s loss to $2.00.

• Convertible Arbitrage:– Company A’s common stock trades at $10.00 per share; they have

convertible bonds convertible at $10.00 and pay a 6% coupon. – The Convertible Bond Fund Manager purchases $1mm bonds and

sells short $1mm shares at $10.00. – The Fund will now collect the 6% coupon plus the interest on the

short rebate (e.g., a broker rate) of 1.5%.– The manager has generated an annualized return of 7.5%.

Global Futures MarketNotional Amounts

040302010099989796959493929190

20

15

10

5

0

800

600

400

200

0

US$ trillions US$ billions

Interest Rate (L)

Equity Index (R)

Currency (R)

Global Options MarketNotional Amounts

040302010099989796959493929190

25

20

15

10

5

0

140

120

100

80

60

40

20

0

US$ trillions US$ billions

Interest Rate (L)

Equity Index (L)

Currency (R)

Interest RatesFed Funds Rate and the 10-year Treasury

200320022001200019991998199719961995199419931992

10

8

6

4

2

0

Percent

Fed Funds Rate10-Year Government Bond

20042003200220012000

-2.0

-2.5

-3.0

-3.5

-4.0

-4.5

-5.0

130

120

110

100

90

80

70

U.S. Trillions Jan 2000 = 100

Trade Deficit and US Dollar

Yen/Dollar (R)

Euro/Dollar (R)

Cumulative Trade Deficit Since 1985 (L)

$4.8 trillions as of 2004Q3

Lower Dollar, Higher Oil Price

Crude Oil

Trade-weighted dollar

20042003200220012000

200

180

160

140

120

100

80

60

145

136

127

118

109

100

91

82

Jan 2000 = 100 Jan 2000 = 100

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