Hedge Funds - IIM Raipur

8/10/2019 Hedge Funds - IIM Raipur

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Hedge Funds


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Hedge funds are investment pools that are relatively uncon

in what they do. They are relatively unregulated (for now), cvery high fees, will not necessarily give you your money backyou want it, and will generally not tell you what they do. Thesupposed to make money all the time, and when they fail atinvestors redeem and go to someone else who has recently making money. Every three or four years they deliver a one-hundred year flood. They are generally run for rich people inSwitzerland, by rich people in Greenwich, Connecticut.

-Cliff Asness, Journal of Portfolio M


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What is a hedge fund?

Hedge Fund- A fund that can take both long and short positions

use arbitrage

buy and sell undervalued securities

trade options or bonds, and

invest in almost any opportunity in any market where it fimpressive gains at reduced risk.


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Opinions differ regarding the definition of the phrase HedgThe most commonly accepted definition is that a hedge funfunds which:

Have an absolute return performance objective

Allow the manager to be active on both the long and short sides o

markets

Compensate the manager with performance related fees

Allow the manager tremendous flexibility in investment style and


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To hedge ones bets i.e. betting on other side to limit the of loss on a speculation.

Hedge funds pool of funds of the highly influential investors,

open to limited number of investors require high investment

include high expertise based investment strategies and Risk mana


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Targeted Investments

They can invest in any type of asset class or opportunity luring in the be it

options,

derivatives,

equities,

bonds,

undervalued securities,

currencies,

Commodities

events such as mergers or bankruptcies,

domestic as well as international markets where they can expect toattractive returns in all kind of risky situations.


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Goal of the fund?

Lets break it up

The primary aim of most hedge funds is to Reduce volatility and risk

while attempting to preserve capital, and

deliver positive returns under all market conditions.

In other words Attempting to minimize the risk i.e. to hedge.

Protecting capital (i.e. the private pool of funds)

Generating superior returns in all kinds of markets (they are readybearish markets also)


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Hedging Strategies

There are approximately 14 distinct investment strategies ushedge funds

Key: All hedge funds are not the same. The investment returns, vorisk vary enormously among the different strategies


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Styles of Hedge Funds

Aggressive Growth:Invests in equities expected to experience accelegrowth of earnings per share

Hedges by shorting equities where earnings disappointment is expshorting stock indexes

Tends to be "long-biased." The long-bias hedge fund strategy essentially serves as an investment halfway house in between a m

and a long-only fund. Rather than putting on positions that cancel out as found in a market neutral fsubstantial long exposure as in a long-only fund, a long-bias fund maintains a differing ratio of long (compared to short positions) that usually exceeds 40%. With this definition in mind, a hedge fund wequity strategy could transition into a long-bias hedge fund, and vice versa, depending on how its asallocated.

this type of long/short strategy, for example, investing at a 130/30 ratio of long to short (130% longor 120/20, are known as long bias strategies. Fewer hedge funds employ a short bias over the longmarkets tend to move up over time.

Expected Volatility:High


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Styles of Hedge Funds (Contd.)

Distressed Securities:Buys equity, debt, or trade claims at deep of companies in or facing bankruptcy or reorganization

Profits from the market's lack of understanding of the true vadeeply discounted securities

Majority of institutional investors cannot own below investmsecurities.

Results generally not dependent on the direction of the mark

Expected Volatility:Low - Moderate


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Emerging Markets:Invests in equity or debt of emerging (lemature) markets that tend to have higher inflation and volagrowth

Short selling is not permitted in many emerging markets, and, theeffective hedging is often not available

Expected Volatility:Very High


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Funds of Hedge Funds:Mix and match hedge funds and other poinvestment vehicles

Blend of different strategies and asset classes aims to providelong-term return than any of the individual funds.

Returns, risk, and volatility can be controlled

Capital preservation is generally important

Volatility depends on the mix and ratio of strategies employe

Expected Volatility:Low - Moderate - High


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Income:Invests with primary focus on yield or current incomerasolely on capital gains

May use leverage to buy bonds or fixed income derivatives, iprofit from principal appreciation and interest income.

Expected Volatility:Low


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Macro:Aims to profit from changes in global economies

Typically brought about by shifts in govt. policy that impact inrates, in turn affecting currency, stock, and bond markets

Uses leverage and derivatives to accentuate the impact of mamoves

Uses hedging, but largest performance impact is from the levdirectional investments



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Market Neutral - Arbitrage:Attempts to hedge out most markettaking offsetting positions, often in different securities of the sam

Eg. Can be long convertible bonds and short the underlying isequity.

Focuses on obtaining returns with low or no correlation to boequity and bond markets

Relative value strategies include fixed income arbitrage, mortbacked securities, capital structure arbitrage, and closed-endarbitrage



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Market Neutral - Securities Hedging:Invests equally in long andequity portfolios generally in the same sectors of the market

Market risk is greatly reduced

Effective stock analysis and stock picking is essential to obtainmeaningful results

Leverage may be used to enhance returns Usually low or no correlation to the market



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Market Timing:Allocates assets among different asset classes deon the manager's view of the economic or market outlook.

Portfolio emphasis may swing widely between asset classes

Unpredictability of market movements, and the difficulty of t

entry and exit from markets increase volatility

Expected Volatility:High


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Opportunistic:Investment theme changes from strategy to stratopportunities arise to profit from events such as IPOs, hostile bid

May utilize several of these investing styles at a given time

Not restricted to any particular investment approach or asset

Expected Volatility:Variable


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Multi Strategy:Investment approach is diversified by employing vario

strategies simultaneously to realize short- and long-term gains

Other strategies: Systems trading such as trend following and varidiversified technical strategies

Allows the manager to overweight or underweight different strate

capitalize on current investment opportunities

Expected Volatility:Variable


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Short Selling:Sells securities short, in anticipation of being able repurchase them at a future date at a lower price

Result of anticipated overvaluation, earnings disappointmentcompetition, change of management, etc.

Often used as a hedge to offset long-only portfolios by those expect bearish cycle.



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Special Situations:Invests in event-driven situations such as mehostile takeovers, LBOs etc.

May involve simultaneous purchase of stock in companies beacquired, and the sale of stock in its acquirer, hoping to profispread between the current market price and the ultimate puprice of the company

Results generally not dependent on direction of market

Expected Volatility:Moderate


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Value:Invests in securities perceived to be selling at deep discoutheir intrinsic or potential worth

Such securities may be out of favor or under-followed by ana

Long-term holding, patience, and strong discipline are often

until the ultimate value is recognized by the market

Expected Volatility:Low - Moderate


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Various Hedge Fund Strategies

Emerging Markets Invest in emerging markets Emerging markets offer less options for short selling, so these are mostly

and employ growth or value approach to investing in equities. These can be illiquid & carry a high risk due to correlation of emerging e

Convertible Arbitrage Make profit from arbitrage of convertible securities Make money from mispricing & volatility

Usually buy a convertible bond, and take a short position in underlying e Long- Short Equity

Base strategy of the initial hedge fund formations by Jones. Hedging portfolio of longs by portfolio of shorts. Main focus on the stock picking opportunities.


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Global macro

Invest in developed as well as developing countries. Enough flexibility. Can invest in any security in any market where there i

opportunity.

Event Driven Focus on events of corporate life cycle like acquisitions, buybacks, deme

offs etc,.

Merger/Risk Arbitrage Focus on the companies which are going through any merger or takeove Both the acquiring company and the target. The risk is deal risk rather than a market risk.


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Distressed Securities Buying the bonds or securities of companies facing or approaching

bankruptcy or restructuring

Tries to benefit from the price movement of these securities.

Equity Market Neutral Market timing rather than stock picking.

Taking long and short position in the undervalued and overvalued

Has low volatility.

Some Other Strategies


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Some Other Strategies

Fixed Income Arbitrage

-Seeking arbitrage opportunities in in Fixed Income Securities

-Interest rate arbitrage

-Use of derivatives like Interest Rate futures, Caps, floors etc.

Managed Futures

-Strategic investment or arbitrage in futures(usually Commodities and C

-Spot-future arbitrage

-Contango and Backwardation arbitrage

-Calendar spread in futures

Market Directional

-Market momentum strategy

-for very short term

-example is Jobbing


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Things to Note:

FICTION:All hedge funds are volatile -- they all place large directiona

securities and commodities, while using lots of leverage FACT: Less than 5% of hedge funds are global macro funds. Most h

use derivatives only for hedging or don't use derivatives at all, andno leverage.

Some hedge funds don't actually hedge against risk. The term is appwide range of alternative funds, and encompasses funds that use highstrategies without hedging against risk of loss


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Management of Hedge funds

Most hedge funds are managed by experienced investment

professionals

Highly specialized

Trade only within their area of expertise and competitive

advantage

Remuneration heavily weighted towards performance in

Usually have their own money invested in their fund


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How is a Hedge Fund different from a MFund?

Hedge funds traditionally reserved for clients with initial

investment of $1 million. Mutual fund companies beginnoffer hedge fund products to wider client base

There are 5 key differences between them based on:1. Performance Evaluation

2. Level of regulatory control3. Basis for Remuneration of Management4. Portfolio Protection5. Dependence on Markets


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Differences (Contd.)

Performance Evaluation:

Mutual funds are measured on relative performance cto a relevant index or to other mutual funds in their se

Hedge funds are expected to deliver absolute returns ucircumstances, even when the relative indices are dow

Level of Regulation: Unlike hedge funds, mutual funds are highly regulated

restricting the use of short selling and derivatives. Makdifficult to outperform market, or protect assets in dow


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Remuneration for Management

Mutual Fund managers are paid based on a % of AUM. Hedge fmanagers performance-related incentive fees plus a fixed fee

Portfolio Protection

Mutual funds are not able to effectively protect portfolios again

markets other than by going into cash or by shorting a limited astock index futures

Hedge funds are often able to protect against declining marketsvarious hedging strategies, and can generate positive returns evdeclining markets.


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Dependence on Markets The future performance of mutual funds depends on t

direction of the equity markets.

The future performance of many hedge fund strategiesbe highly predictable and not dependent on the directequity markets.


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Fund of Funds

A fund of funds mixes the most successful hedge funds and other poo

vehicles, spreading investments among many different funds or inves

Hedge fund strategies are complex and varied in their ranges of risk/rwithin a particular style, two managers can apply different amounts oinsurance and leverage to his/her portfolio

A fund of funds blends together funds of different strategies and asseorder to accomplish:

More consistent return (than any of the individual funds) Spreading out the risks among a variety of funds Meeting a range of investor risk/return objectives


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Indian Context

Asian countries are offering many opportunities

Market in UK and US are facing huge meltdowns investors are finding hard to sustain there money making options are drying

India is offering various necessary conditions for hedge funds to with its

secondary market liquidity Futures options, etc.


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Why India?

Investment can be made through FII (Foreign Institutional In

route.

Doesnt charge anything on performance or profit of the fun

Thus giving India a plus point from others

Thus attracting more HNIs to enter India through these.

Incremental Nominal GDP (in Bi


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Incremental Nominal GDP - (in BiUS $)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

China India United

States

Brazil Mexico Indonesia Russia United

Kingdom

Germany Japan

2035-2050

2020-2035

2006-2020


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Working Age Population Growth Rates (% p.a.

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%% p.a.

Source: PwC Report

Hedge Funds in India


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Cater toIndividualInvestors

FirstImplication

Uncorrelatedreturns

Surge inearnings

SecondImplication

Increase indemand

Increasecompetition

Reducinginvestment

fees

Essentials forHFs

Registration

Independentaudit

Transparency

Properdisclosure

Performance of Indian Hedge Funds


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Performance of Indian Hedge Funds

$44,000 million AUM (assets under management) of all Indian hedgfunds

Indias high beta market generate effective returns.2006

Bull Run

Q-India, Halbis, Baer Capital, Insynergy & FMG outperformed majorhedge fund indices.

2007

Experiment with complex strategies, resulted hard on the returns.

India index was the worst performing index with loss of around 50%2008

More cautious in year 2009 and 2010

Taking some worthwhile sectors and stock calls2009

Gloomy picture of hedge fund success

First 7 months having almost deep losses and very bleak returns

Funds which focused on inflation sensitive India gained around

15.48% according to HFRX India index

2010


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HFRX

The Hedge Fund Research Index

Most Widely followed index for Hedge Fund Performance

It is comprised of all eligible hedge fund strategies. All strategies are eweighted.

Evaluates the performance of Hedge Funds based on Absolute ReturnRelative Risk.

As a component of the optimization process, the index selects constiwhich exhibit lower volatilities and lower correlations to standard direbenchmarks of equity market and hedge fund industry performance.

HFRX India is an index for the Indian Hedge Funds.

HFRX Returns 10 09 08 07 06 Avg Stdev Min


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Global Hedge Fund 5.19 13.4 (23.25) 9.26 2.72 1.46 14.40 (23.25)

Equal Weighted

Strategies

5.29 11.44 (21.9) 8.83 1.28 0.99 13.35 (21.9)

Absolute Return (0.12) (3.58) (13.09) 7.43 (0.03) (1.88) 7.45 (13.09)

Market Directional 9.32 29.34 (29.7) 10.45 4.2 4.72 21.48 (29.7)

Convertible

Arbitrage

8.76 42.46 (58.37) 9.57 (5.69) (0.65) 36.77 (58.37)

Distressed Securities 8.34 (5.6) (30.69) 9.56 1.21 (3.44) 16.41 (30.69)

Equity Hedge 8.92 13.14 (25.45) 9.23 4.19 2.01 15.67 (25.45)

Equity Market

Neutral

2.64 (5.56) (1.16) 4.76 0.21 0.18 3.93 (5.56)

Event Driven 1.98 16.59 (22.11) 10.32 2.81 1.92 14.70 (22.11)

Macro (1.73) (8.78) 5.61 5.61 6.67 1.48 6.64 (8.78)

Merger Arbitrage 5.69 8.14 3.69 10.73 3.72 6.39 3.03 3.69

Relative Value

Arbitrage

7.65 38.47 (37.6) 10.65 (0.97) 3.64 27.39 (37.6)

Dow Jones Credit Suisse

indices

10 9 8 7 6 Avg Stdev Min Max R


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indices

Convertible Arbitrage 0.9 3.24 -2.79 0.11 1.04 0.50 2.18 -2.79 3.24 7

Emerging Markets 0.81 2.04 -2.19 2.51 1.8 0.99 1.89 -2.19 2.51 1

Event Driven 0.6 1.6 -1.46 1.64 1.03 0.68 1.27 -1.46 1.64 6

Fixed Income Arbitrage 0.38 0.3 1.01 1.29 0.86 0.77 0.42 0.3 1.29 3

Global Macro 0.69 0.48 0.98 1.21 0.39 0.75 0.34 0.39 1.21 4

Long/Short Equity 0.58 1.47 -0.85 1.5 1.02 0.74 0.97 -0.85 1.5 5

Managed Futures 1.14 -1.08 2.29 1.39 0.99 0.95 1.24 -1.08 2.29 2

HF strategies and Systematic risk


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HF strategies and Systematic riskexposure


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Evolution of HF strategies


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Modern day HF strategies


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Empirical Findings

Returns are considerably high during a volatile market which is mean

nature

Returns during a trending market in some of the HF strategies is low anegative in some cases

Well established and High Corpus HFs give a lower returns compared relatively newer peers who have small corpus


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John Paulson(HF: Paulson and Co.)His claim to fame is his pay check for 2007: he is reported to have made $3.7 billion. Strategy: Short-selling sub prime mortgage

He made a profit of $15 billion for his investors in 2007. His flagship fundgenerated a return of 599%.

In 2010, he beat a hedge-fund record by making nearly $5 billionHis Flagship Fund (Paulson Advantage Fund) was down by 40% as on Sept. 2011


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George Soros(HF: Soros Fund Management)

Short sold 10 Billion pounds in 1992 and made 1.1 Billion $ in a singleday (Black Wednesday)

Similar speculation over the currency of Association of Southeast AsianNations (ASEAN) in 1997

As of March 2012 Soros was listed 22ndin Forbs among the richestpeople in the world


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Christopher Hohn

The hedge fund he manages reportedly lost $1 billion in a single month,June 2008. The size of his hedge fund went from $8 billion to $7billion.

Interestingly Hohn was a topper at HBS.

Other smart people who lost money through Hedge Funds are theNoble Laureates Myron S. Scholesand Robert C. Merton(The LTCMcase)

H d F d R l ti I I di
http://en.wikipedia.org/wiki/Myron_S._Scholeshttp://en.wikipedia.org/wiki/Robert_C._Mertonhttp://en.wikipedia.org/wiki/Robert_C._Mertonhttp://en.wikipedia.org/wiki/Myron_S._Scholeshttp://en.wikipedia.org/wiki/Myron_S._Scholes


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Hedge Fund Regulations In India

SEBI regulation seeks to cover all types of funds broadly under 3 categ

Category I AIFthose AIFs (Alternative Investment Funds) with pspillover effects on the economy

Category II AIFthose AIFs for which no specific incentives or coare given by the government or any other Regulator; which shall no

leverage other than to meet day-to-day operational requirements

Category III AIF those AIFs including hedge funds which trade wto make short term returns; which employs diverse or complex tradstrategies and may employ leverage including through investment unlisted derivatives.

R l t C t i t


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Regulatory Constraints

Restricting participation:

The Alternative Investment Fund shall not accept from an investoinvestment of value less than rupees one crore. Further, the AIF shminimum corpus of Rs. 20 crore.

Avoiding wealth concentration hazards: The fund or any scheme of the fund shall not have more than 1000

Preventing Conflict of Interest: For a Hedge Fund, the continuing interest shall be not less that 5%

corpus or rupees ten crore, whichever is lower.

Reg lator Constraints (contd )


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Regulatory Constraints (contd..)

Trading in Secondary Market:

Units of AIF may be listed on stock exchange subject to a minimumlot of rupees one crore. However, AIF shall not raise funds throughExchange mechanism

Against Concentration Alpha and Speculation: Hedge Funds shall invest not more than 10% of the corpus in one

Company.

Preventing Moral Hazard: AIF shall not invest in associates except with the approval of 75% o

by value of their investment in the Alternative Investment Fund

The Category III of AIFs (the Hedge Funds)


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The Category III of AIFs (the Hedge Funds)

Proper disclosure:

Category III Alternative Investment Funds shall enscalculation of the net asset value (NAV) shall be disthe investors at intervals not longer than a quarter foended Funds and at intervals not longer than a monopen ended funds.

Category III Alternative Investment Fund shall providquarterly reports to investors within 60 days of end oquarter.

How Hedge Fund Leverage Works (Exh


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g g (11.1)Hedge fund investor capital can be leveraged in several ways to enhance overall returns.

Direct forms of leverage:

Bank borrowingsHedge funds can take out margin loans (buying securities on margin) from banks. For exampmargin on security ABC, a hedge fund could buy $10 worth of securities by paying only $2 upbank supply the remaining $8 in the form of a loan. To protect its loan balance, the bank reqdeposit an agreed amount of securities as collateral. If the market value of the ABC securitierequire additional collateral from the hedge fund (margin call) to further protect itself.

Repossession agreements (repos)

Usually used by hedge funds to finance debt security purchases, a repo transaction involves o

sell a security to another party for a given price and then buying it back later at a higher priceImplicit forms of leverage:

Short selling

Short selling is the practice of selling securities borrowed from banks or other counterpartiessale of these borrowed securities are used to buy other securities a practice known as long

How Hedge Fund Leverage Works - Exhibit


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g gof 2)

Short selling

Short selling is the practice of selling securities borrowed from banks or other counFunds raised from the sale of these borrowed securities are used to buy other securpractice known as long/short trading.

Off-balance-sheet leverage through derivatives and structured products

Derivatives include options, swaps, and futures. Investors can gain much larger riskan asset class through the use of derivatives than from buying the assets directly. Inthe high-risk portions of structured products such as collateralized debt obligations provide implicit leverage.

Through the first half of 2008, total hedge fund industry leverage was estimated to betimes investor capital.

Source: Farrell, Diana, et al. The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity AreGlobal Capital Markets. McKinsey Global Institute Oct. 2007.

A t d t d ti t d t t l i t bl t 1 $ i t illi

Exhibit 11.2 Hedge Funds Leveraged Assets Fell from $6.6 Trillion to $2.4 Trillion in Less Than a One-YearFor recentfigures refer

Figure 11.1


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Note 1: Includes leverage from debt and off-balance sheet leverage through derivatives and other instrument

Note 2: Leverage ratio = (total leverage + AUM) / AUM

Source: McKinsey Global Institute; Global Capital Markets Survey; Dresdner Kleinwort Equity Research; Intern

Financial Services, London; Financial Risk Management, Ltd.; Financial Services Authority

Assets under management and estimated total investable assets1, $ in trillions

Implied

Leverage

Ratio2(total)

2.93.4

4.8

6.5 6.6

3.6

2.4

2.9 3.1 3.4 3.4 3.5 2.6 2.0

-64%

1.0 1.1 1.4 1.9 1.9

1.4 1.2

0.4 0.60.8

1.30.8

0.70.3

1.51.7

2.6

3.3

3.9

1.5

0.9

2004 2005 2006 2007 H1-08 H2-08 Q1-09

Leverage through derivative positions

Leverage through debt

Assets under management

g

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Estimated Total Number of Hedge FundsversusFund of Funds

1990 20008

Exhibit 11.3 (2 of 2)For recentfigures refer

Figure 11.3


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Source: Hedge Fund Research, Inc.

199020008

80 127 168 237 291 377 389 426 477 515 538 550 781

1,2321,654

1,996 2,2212,46

530 694 937

1,2771,654

2,0062,392

2,5642,848

3,102 3,335

3,904

4,5985,065

5,782

6,665

7,2417,6

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Fund of Funds

Hedge Funds

of text book

page 223

Estimated Growth of Assets

Hedge Fund Industry 1990 2008 $ in billions


Figure 11.4


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Hedge Fund Industry 19902008, $ in billions

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

of text book

page 224

Estimated Growth of Assets

Fund of Fund Industry 1990 2008 $ in billions


Figure 11.5


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Source: Hedge Fund Research, Inc.

Fund of Fund Industry 1990 2008, $ in billions

0

100

200

300

400

500

600

700

800

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

of text book

page 224

Share of High Net Worth Individuals Has Fallen

Exhibit 11.5For recentfigures refer

Figure 11.6


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Source: McKinsey Global Institute; Hennessee Group LLC; International Financial Services, London estimates

5% 10% 12% 14% 15% 15% 15% 15% 12% 11% 14% 15%

9%8% 7%

7% 8% 7% 8% 8% 7% 8%12% 11%11%

10% 8% 8% 9% 9% 9% 9%

7%18%

12% 12%14%18% 20% 17%

20% 27% 24% 24% 30%

23%31% 32%

61% 54% 53% 54%

48% 42% 44% 44% 44% 40%

31% 30%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

High net-worth

individuals

Fund of hedge fu

Endowments and

foundations

Corporations and

institutions

Pension funds

of text book

page 226

Top 10 Hedge Funds by Assets Under Management at the End of 2008

Exhibit 11.6

Firm Region AUM ($bn)

For recenttable 11.1

of text book


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Note 1: As of December 31, 2008. All other figures as of January 1, 2009.

Note 2: Tied for 10thplace.

Source: Absolute Return Billion Dollar Club, March 2009 rankings

Bridgewater Associates U.S. 38.6

J.P. Morgan U.S. 32.9

Paulson & Co. U.S. 29.0

D.E. Shaw Group U.S. 28.6

Brevan Howard1 Europe 26.8Och-Ziff Capital Management U.S. 22.1

Man AHL1 Europe 22.0

Soros Fund Management U.S. 21.0

Goldman Sachs Asset Management1 U.S. 20.6

Farallon Capital Management2 U.S. 20.0

Renaissance Technologies2 U.S. 20.0

page 227

Hedge Fund Revenues are Highly Concentrated in the Top 205 Funds

Exhibit 11.7

Hedge Fund Revenue Pool for 2006

For recentfigures refer

Figure 11.7

f b k


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Source: McKinsey Global Institute; Lipper Hedge World; Merrill Lynch; McKinsey Global Institute hedge fund

interviews

43%

18%

13%

26%

Hedge Fund Revenue Pool for 2006

>$5bn (64 funds)

$3-5 bn (64 funds)

$2-3 bn (77 funds)


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Note: A bull market (denoted in green shading) is a 20% rally preceded by a 20% decline in the DJIA; a bear m

(denoted in red shading) is a 20% decline preceded by a 20% rally in the DJIA.

Source: Hedge Fund Research, Inc.; DJIA data provided by Commodity Systems Inc.

y g ,

HFRI Fund Weighted Composite Index

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Dec-94

Jun-95

Dec-95

Jun-96

Dec-96

Jun-97

Dec-97

Jun-98

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Jun-06

Dec-06

Jun-07

Dec-07

of text book

page 229

Since 1990, Hedge Fund Strategies Have Outperformed Both Bonds andEquities (Even Accounting for Risk)

Risk vs. return for hedge fund strategies compared to blended portfolios of bonds and equities,

Exhibit 11.9


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Source: McKinsey Global Institute; Hedge Fund Research, Inc.; Datastream

1990 - 2008

Relative Value

Event-Driven

Equity Hedge

Macro

3 4 5 6 7 8 9 10 11 12 13

7

8

9

10

11

12

13

14

15

Standard Deviation %

AverageReturn%

Portfolio composition:

100% equities, 0% bonds

Additional 5% bonds, moving to th0% equities, 100% bonds

Top Quartile Hedge Funds Outperformed U.S. Equities and Bonds1

Average annual returns (net of fees) by strategy for risk-adjusted quartiles, 20012007, %

Exhibit 11.10


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Note 1: Quartiles are defined based on risk-adjusted performance, defined using fund Sharpe ratio between 2

2007. The Sharpe ratio is given by Average (RRf) / Standard Deviation (R), where R is the return and the ben

rate Rf is the S&P 500 average between 2001 and 2007 (2.43%).

Source: McKinsey Global Institute; Hedge Fund Research, Inc.

0.2

0.4

11.2

19.4

4th

Quartile

3rd

Quartile

2nd

Quartile

1st

Quartile

Equity Hedge

4.1

12.7

15.4

31.3

Macro

-2.6

4.0

13.9

19.0

Event-Driven

2.2

7.5

9.9

13.6

Relative Value

6.12.4 6.12.4 6.12.4 6.12.4

S&

Leh

Ag

Bo

Academic Research on Hedge Fund Performance

Due to limitations in the availability of hedge fund performance data, a clear assessment of indu

Exhibit 11.11 (1 of 2)


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performance is difficult to obtain. However, based on what is available through the small but gr

number of academic papers on hedge funds, a number of observations can be made:

Hedge funds in aggregate have slightly outperformed the public equities market.

o Top-quartile hedge funds significantly out-perform equities.

Hedge funds in aggregate are slightly less volatile than the public equities market.

Absolute returns (alpha, or returns uncorrelated with the broader market) have been more

elusive:

o For many hedge fund strategies, over 70% of returns reflect returns of common market in

o Fund of funds delivered no alpha.2

o 3% of annual hedge fund returns can be attributed to alpha.3

o Top quartile hedge funds are able to achieve outsized alphas (as high as 15% annually), badata from a period of a few years.4

These findings suggest that investing in market indices can be a reasonable and less expensive

alternative to expensive hedge funds (with the exception of top performing hedge funds).

It is important to note that there are limitations to these observations as imperfect data can crea

number of biases:

Academic Research on Hedge Fund Performance

Selection bias: participation in hedge fund databases is voluntary.



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Survivorship bias: unsuccessful funds that have folded are not included in most hedge fund

databases.

Backfill bias: once a hedge fund registers with a database, returns from years prior to registra

are provided and incorporated into the database as well. Funds are typically included in data

after they have accumulated a good performance track record.

Liquidation bias: returns are no longer reported before a fund enters into final liquidation.

Although difficult to aggregate the effect of all of these biases, by some estimates, just survivors

and backfill bias together can inflate industry returns by as much as 4%.5

Note 1: Hasanhodzic, Jasmina and Andrew W. Lo, Can hedge -fund returns be replicated?: The linear case. JoInvestment Management, Q2 2007, Vol. 5, No. 2.

Note 2: Fung, William, et al. Hedge funds: Performance, risk, and capital formation. AFA 2007 Chicago Meetpaper, 19 Jul. 2006.

Note 3: Ibbotson, Roger G. and Peng Chen. The A,B,Cs of hedge funds: Alphas, betas and costs. Yale ICF worpaper, Sep. 2006.

Note 4: Kosowski, Robert, et al. Do hedge funds deliver alpha? A Bayesian and bootstrap analysis. Journal ofFinancial Economics, Vol. 84, No. 1, Apr. 2007, pp. 229-64.

Note 5: Fung, William and David Hsieh. Hedge funds: An industry in its adolescence. Federal Reserve Bank oAtlanta, Economic Review, Q4 2006, Vol. 91, No. 4.

Source: Farrell, Diana, et al. The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity Are ShapGlobal Capital Markets. McKinsey Global Institute Oct. 2007.

Annualized Total Return, %

Exhibit 11.12 Comparison of Hedge Fund Returns to the S&P 500 Indexs Returns, 2000


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Source: Credit Suisse/Tremont; S&P 500 data provided by Commodity Systems Inc.

4.9% 4.4% 3.0%

15.4%9.6%

7.6%

13.9%12.6%

-19

-10.1%-13.0%

-23.4%

26.4%

9.0%

3.0%

13.6%

3.5%

2000 2001 2002 2003 2004 2005 2006 2007 2

Hedge funds

S&P 500

Travails of the Hedge Fund Market in 2008

Hedge funds are supposed to thrive in rough markets.



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Not in 2008. A historic decline in stocks, and troubles in almost every part of the bond market, d

hedge funds their worst year on record. By the end of the year, investors were scrambling to get

bringing an end to years of industry growth and creating uncertainty about the future of major

components of the business.

Through December 2008, hedge funds globally lost 19% on average, according to Hedge FundResearch, a Chicago firm that tracks the industry. Although that's better than the 38% loss on the

Standard & Poor's 500-stock index (including dividends) over the same period, it's far from the g

most funds posted for more than a decade. The biggest fund category within hedge funds, long-

funds (where the strategy is to buy some shares while betting against others), was down 23% on

average. Funds that invest in emerging markets dropped 31%.

Assets controlled by hedge funds tumbled to $1.4 trillion from nearly $2 trillion at the start of th

according to Hedge Fund Research, and continued falling in 2009.

Fund managers and their investors are trying to figure out what went wrong. One conclusion: Tomany funds bought the same assets. As markets fell in September and October, and hedge funds

under pressure, many moved to sell investments, sending prices even lower and causing losses f

other funds that hadn't yet sold.

Stocks favored by hedge funds performed even worse than the overall market, according to data

Goldman Sachs. An index of 50 stocks "that matter most" to hedge funds lost nearly 45%, includ

dividends, compared with a loss of 38.5% on the S&P 500.

Travails of the Hedge Fund Market in 2008

One problem for many hedge funds was the amount they hold of hard-to-trade assets, such as lo

real estate holdings and stakes in small private companies These illiquid investments at one tim



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real-estate holdings, and stakes in small, private companies. These illiquid investments at one tim

accounted for 20% of some fund portfolios, estimated to total about $400 billion. As financial m

come under pressure, it becomes harder to get out of these investments, or even to value them

accurately.

Another problem for the industry was the fallout from December 2008s arrest of Bernard Mado

$50 billion Ponzi scheme. While Madoff wasn't a hedge-fund manager, his business of overseeing

private accounts for wealthy individuals in tight-knit social circles from Palm Beach, to Long Islan

well as for charities and private-banking clients all across Europe, rattled investor trust in private

investment managers in general.

The scandal also tainted fund of funds, the professional investment firms that raise money from

to invest in a portfolio of other investment funds. Several such firms channeled billions of dollars

Madoff through feeder funds, raising questions about how much due diligence those firms perfo

and whether clients' investments are as diversified and safe as they should be.

Source: Zuckerman, Gregory and Jenny Strasburg. For Many Hedge Funds, No Escape. Wall Street Journal 2 J

2009.

Hedge Funds Account for a Significant Share of Trading Volume

Hedge Funds Estimated Share of Trading, %

Exhibit 11.14


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Source: McKinsey Global Institute; NYSE; LSE; U.S. Bond Market Association; IMF; Greenwich Associates; Finan

News; Gartmore; Stern School of Business; British Bankers Association; ISDA; McKinsey CIB practice

32

47

45

30

6

25

30

50

Leveraged Loans

Distressed Debt

Emerging Market Bonds

Credit Derivatives - Structured

Credit Derivatives - Plain Vanilla

High-Yield Bonds

U.S. Government Bonds

Cash Equity on NYSE and LSE

Gating

The illiquidity of hedge funds often means that, even if investors realize the manager of their fun

run into trouble it could be months before they can get their money back Even then arrangeme

Exhibit 11.15


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Source: DealBook, Third Bear Stearns Fund Skids on Mortgages. New York Times 1 Aug. 2007.

run into trouble, it could be months before they can get their money back. Even then, arrangeme

called gates may restrict the proportion of an investors holdings that can be redeemed. Hedge

managers use gates to control redemptions during difficult markets. For example, in the throes o

subprime mortgage meltdown of 2007, an article in the New York Timesblog DealBook describ

how the Bear Stearns Asset-Based Securities Fund had moved to suspend investor redemptions

According to a Bear spokesman, *+ we believe by suspending redemptions we can ensure the blong term results for our investors *+ we dont believe it is prudent or in the interest of our inve

to sell assets in the current market environment. The ability of the Bear Stearns hedge fund ma

to suspend investor redemptions illustrates the power of gating. Because the fund had incurred

losses, investors in the fund likely would have pulled their money out were they not bound by ga

Thus, gating allows hedge fund managers to have greater control over their investors funds by

preventing investors from obtaining redemptions at inopportune times.


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Recent Hedge Fund IPOs Have Underperformed the Broader Market

Och-Ziff Capital Management Group LLC (NYSE:OZM) versus the S&P 500 Index

November 14 2007 (IPO date) to December 31 2008



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Source: Data provided by Commodity Systems Inc.

November 14, 2007 (IPO date) to December 31, 2008

-100%

-90%

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

Nov-07 Dec-07 Feb-08 Mar-08 May-08 Jun-08 Aug-08 Sep-08 Nov-08 D

OZM S&P 500

Why Use a Fund of Funds Firm?

Diversification and access

o Immediate diversification with relatively modest capital investment

Exhibit 11.17


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Source: Grosvenor Capital Management

o Immediate diversification with relatively modest capital investment

o Access to certain managers who might otherwise be closed for investment

Value-added investment process

o Fundamental knowledge of many different investment strategies

o Network of industry relationships assists in filtering manager universe

o Staffing resources and expertise necessary for manager due diligence and monitoring

o Understanding of quantitative and qualitative portfolio construction issues

o Dynamic process that requires constant attention

Operational efficiencies

o Legal due diligence and document negotiation

o Consolidated accounting, performance and financial reporting

o Cash flow management

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