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Introduction to Hedge Funds

Introduction to Hedge Funds 2

Hedge funds – a separate asset class?

History, definition and characteristics of hedge funds

Risks, returns, correlations

Benchmarks and long term return outlook

Hedge funds in the context of a traditional investment portfolio

Conclusions


Alternative investments

Alternative Asset Class

Hedge funds

Private equity

Commodities

Credit (HY/ABS/MBS/CDOs)

Real estate (resid., comm., infrastr.)

Other (insurance, art, hybrids, etc)

Forecasted Demand Growth

High

High

High

High

High

High


$38,910 $58,370$95,720

$256,720

$539,060

$1,604,600

$57,407$91,431

$4,406$55,340

$23,336 $46,545 $46,907

$1,745,214

$490,580$456,430

$185,750

$1,464,526

$167,790$167,360

$972,608

$1,105,385

$820,009

$625,554

$367,560$374,770

$126,474$60,222

$58,663$73,585

$99,436

$27,861 $36,918

($1,141)

$14,698$70,635

$8,463

($100,000)

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

$800,000

$900,000

$1,000,000

$1,100,000

$1,200,000

$1,300,000

$1,400,000

$1,500,000

$1,600,000

$1,700,000

$1,800,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Q12007

Q22007

Ass

ets (

In $

MM

)

Estimated Assets Net Asset Flow

LTCM

Development of the hedge fund industry, 20% growth pa1949: A.W. Jones launched the first hedge fund1967: George Soros started out2004: Hedge fund industry reached USD 1,000 bn mark2007: Industry at USD 1,700 bn, managed by 3,000-4,000 HF managers in 10,000-15,000 HFs

Source: HFR Industry Report 2007 Q2

InstitutionalInvestors enter

Fed IRhike

USD 1 bn mark reached


Hedge funds are a kind of progressive mutual funds

“OLD” definition of hedge funds

“All forms of investment funds, companies, and private partnerships that» use derivatives intensively for hedging or for directional investing» and/or engage in short-selling» and/or use significant leverage through borrowing.”

“NEW” definition of hedge funds

Active, absolute return oriented investment funds


Hedge funds are more flexible than mutual funds

Specific hedge fund characteristics

Active management, take advantage of market inefficiencies

Focus on absolute performance and risk management

Great flexibility reg. asset classes, markets, trading styles, and instruments

Performance fee, own money invested

Infrequent liquidity and redemption dates

High minimum investment levels

Limited regulation and transparency, albeit improving


It is important to distinguish between FoHFs and HFs

Funds of hedge funds Hedge funds

‘Hedge funds‘

HF1 HF2 HF3 HF n


Managed account

Commonly used legal structures

Offshore limited co.US limited partnershipSwiss mutual fundSwiss participation co.SICAVUnit trustOther

Investment fund Structured product

Principal protected noteIndex certificate (fund-linked note)Call optionTotal return swapCFOConvertible Reinsurance-linked note

Hedge fundFund of funds


Fund of Funds Ltd.

Typical offshore structure of a fund of funds

Investment Manager

Investment Advisor

Custodian

Administrator

Auditor

Investor

Hedge funds

Sponsor


Hedge Fund Ltd.

Typical offshore structure of a hedge fund

Investment Manager/Sponsor

InvestmentAdvisor

Prime Broker

Administrator

Auditor

Investor

Securities

Execution Brokers


The role of the different counterparties

Hedge Fund Ltd Offshore company with articles of association,directors, and several share classes

Investor Holder of the non-voting, participating shares

Sponsor Holder of the voting, non-participating shares

Investment Manager Discretionary portfolio manager, typically offshore

Investment Advisor Non-discretionary ‘advisor’, typically onshore

Auditor Audits the balance sheet and P&L


The roles of the prime broker and the administrator

Prime broker Stock lending and reposLeverageCustody of portfolio securities and cashTrade execution and settlementBack office facilitiesOffice spaceLegal assistance for set upMarketing support („capital introduction“)

Administrator Independent NAV calculationHandling of subscriptions and redemptions


Hedge Fund Portfolio Ltd.

Master-feeder structures

Hedge Fund (Dublin) Ltd.

Hedge Fund (Cayman) Ltd.

Hedge Fund LP

EUinvestorsOffshore investorsUS

investors


Cayman and the US are the most popular hedge fund domiciles

Data: HFR, Harcourt estimates

Hedge Fund Domiciles

US30%

BVI9%

Bermuda8%

Cayman Islands34%

Bahamas2%

Channel Islands3%

Other7%Sweden

1%

Dublin4%

Luxembourg2%


2/3 of hedge fund managers are based in the US, but Europe and Asia are growing faster

Data: Harcourt estimates

Hedge Fund Management Company Locations

Greater NY36%

Other US28%

Other Europe8%

London 18%

Asia10%


Roughly 20% of all assets invested in hedge funds come out ofSwitzerland (directly & indirectly)

Data: Harcourt estimates

Hedge Fund Asset Origins

USA50%

Switzerland20%

Other25%

Japan5%







Conclusions


Harcourt strategy classification framework

Directional Multi-Asset Class Strategies:28. LT Trend-Following CTAs29. ST Systematic Trading CTAs 30. Global Macro 31. Insurance-Linked

Directional Commodity Strategies:24. Metals Trading25. Agricultural Trading 26. Energy Trading27. Power & Emissions Trading

Directional Equity Strategies:15. Long/Short Global Equity16. Long/Short US Equity17. Long/Short European Equity18. Long/Short Japanese Equity19. Long/Short EM Equity20. Long/Short Sectors21. Short-Biased Equity

Directional Fixed IncomeStrategies:5. Long/Short Rates6. Long/Short Credit7. Distressed Securities8. Emerging Markets DebtDirectional

Relative Value Commodity Strategies:22. Multi-Strategy Commodity23. Relative Value Energy

Relative Value Equity Strategies:

9. Multi-Strategy Equity 10. Event Driven Equity11. Convertible & Volatility Arbitrage12. Structured Equity Linked13. Statistical Arbitrage14. Market Neutral Equity

Relative Value FixedIncome Strategies:1. Multi-Strategy Fixed Income2. Fixed Income Arbitrage 3. ABS & MBS4. Asset-Based Lending

Relative Value

CommoditiesEquitiesFixed Income

Directional Multi-Asset Class Strategies:28. LT Trend-Following CTAs29. ST Systematic Trading CTAs 30. Global Macro 31. Insurance-Linked

Directional Commodity Strategies:24. Metals Trading25. Agricultural Trading 26. Energy Trading27. Power & Emissions Trading

Directional Equity Strategies:15. Long/Short Global Equity16. Long/Short US Equity17. Long/Short European Equity18. Long/Short Japanese Equity19. Long/Short EM Equity20. Long/Short Sectors21. Short-Biased Equity

Directional Fixed IncomeStrategies:5. Long/Short Rates6. Long/Short Credit7. Distressed Securities8. Emerging Markets DebtDirectional

Relative Value Commodity Strategies:22. Multi-Strategy Commodity23. Relative Value Energy

Relative Value Equity Strategies:

9. Multi-Strategy Equity 10. Event Driven Equity11. Convertible & Volatility Arbitrage12. Structured Equity Linked13. Statistical Arbitrage14. Market Neutral Equity

Relative Value FixedIncome Strategies:1. Multi-Strategy Fixed Income2. Fixed Income Arbitrage 3. ABS & MBS4. Asset-Based Lending

Relative Value

CommoditiesEquitiesFixed Income


Long/short equity is the most popular hedge fund strategy

Data: HFR, Harcourt estimates

Hedge fund strategies (by # of funds)

Long/Short Equity48%

Relative Value Fixed Income

6%

Relative Value Equity26%

Directional Fixed Income

6%

CTAs & Macro14%

Hedge fund strategies (by AUM)

Long/Short Equity39%

CTAs & Macro22%

Directional Fixed Income

8%

Relative Value Equity26%

Relative Value Fixed Income

5%


Most important hedge fund risks

Market risks: Stock market beta, interest rate duration, credit spreads, FX movements

Strategy risks: Supply/demand in each strategy eg inefficiencies, spreads,capacity; trends/market patterns; specific strategy risks eg merger deal breaks, mortgage prepayments, realized and implied volatilities

Leverage: Amplification effect, funding/margin call risk

Liquidity risks: Bid-ask spread risk, investor redemption risk

Valuation risks: Mark-to-market risk, independent valuations

Company risks: Growth of AUM, style drift, ‘key people‘ risk, back office risk, legal risk


Leverage: many hedge fund strategies are not or only moderately leveraged

No leverage (0 - 1.0 : 1) Some long/short equity fundsDistressed securities Short-biased equity

Low leverage (1.1 - 2.0 : 1) Most long/short equity fundsMost long/short credit fundsMerger arbitrage

Moderate leverage (2.0 - 7.0 : 1) Convertible arbitrageStatistical arbitrageCTAsMortgage-backed securities arbitrage

High leverage (8.0 - 20.0 : 1) Fixed income arbitrage


Leverage vs. market exposure: are hedge funds riskier than traditional mutual funds?

Swiss Stocks Mutual Fund: 95% long stocks, 5% cash=> net long exposure of 95%=> leverage of 0.95:1

Long/Short US Equity Hedge Fund: 85% long stocks, 45% short stocks=> net long exposure of 40%=> leverage of 1.3:1

US Convertible Arbitrage Fund: 300% long convertibles, short delta stocks, short interest rates, short credit=> net long exposure of 0%=> leverage of 6.0:1

Fixed Income Arbitrage Fund: 800% long bonds, 800% short bonds=> net long exposure of 0%=> leverage of 16.0:1

CTA: 20% margin in long and short futures positions=> long exposure 200%, short exposure 200% => leverage of 4.0:1

=> Conclusion: leverage should always be considered in connection with actual market risk exposure, as well as basis risk and other risks

Introduction to Hedge Funds 23Data: HFR HF, Barclay CTA Indices 1994 - Aug 2007

Hedge funds have performed similar to stocks and bonds over the last ten years

0%

2%

4%

6%

8%

10%

12%

14%

16%

0% 5% 10% 15% 20% 25%Standard deviation pa

Ret

urn

pa

MSCI World

Macro

Distressed

CV Arb

EM

Short

Merger Arb

L/S Equity Sector

JPM

Hedge Fund Index

MN Equity

FI Arb

MBS

CTAs

FI HY Fund of Funds


All hedge fund strategies have outperformed stocks since January 2000

Data: HFR, Barclay

50

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Dec

-99

Mar

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MSCI World $ HFR HF Index CV arb Distressed Eq hedge FI arbMBS Merger arb Sector Short-selling CTAs Funds of funds

Introduction to Hedge Funds 25Data: FTSE, HFR, Barclay

Each strategy has a different risk/return profile

2007 July YTD Est.

Ret pa 1994-2007

Ret pa 2000-2007

Stdev pa 2000-2007

Corr MSCI2000-2007

HFRI FoF Index (non-investable, net) 8.19% 7.74% 6.49% 4.41% 0.57HFRI Global HF Index (non-investable, gross) 7.61% 11.57% 8.38% 5.87% 0.76CSFB/Tremont HFs (investable, gross) 5.47% n/a 7.51% 2.98% 0.27FTSEhx (investable, net) 4.46% n/a 5.77% 3.39% 0.32Long/short equity 8.31% 14.04% 7.82% 7.77% 0.73Sector specialists 7.31% 13.98% 6.36% 13.35% 0.66Event driven 7.33% 13.29% 10.62% 5.73% 0.71Distressed securities 6.23% 12.20% 12.61% 4.53% 0.50Emerging markets 18.08% 12.05% 15.09% 10.39% 0.74Merger arbitrage 5.59% 10.17% 7.65% 3.37% 0.46Macro 6.55% 9.89% 8.02% 5.49% 0.29Relative value arbitrage 5.67% 9.78% 8.74% 2.18% 0.40MBS arbitrage 2.50% 9.30% 8.48% 3.62% 0.10Convertible arbitrage 4.16% 9.15% 7.97% 3.27% 0.09Market neutral equity 4.83% 7.89% 6.08% 2.72% -0.02Statistical arbitrage 7.04% 7.71% 5.15% 3.68% 0.59High yield 1.49% 7.20% 6.87% 3.69% 0.46Fixed income arbitrage 1.81% 5.88% 6.28% 2.37% 0.05CTAs 1.80% 5.48% 5.10% 7.41% -0.13Short-selling 0.88% 0.79% 5.54% 20.39% -0.71MSCI World 5.54% 7.27% 1.29% 13.50% 1.00JPM Global Bonds 1.58% 6.90% 5.71% 2.89% -0.31


10.2%

16.5%14.2%

6.1%

23.8%

17.0%20.5%

33.2%

17.4%

5.6% 4.0%0.7% 0.4%

3.5%7.1%

-2.7%

-19.4%-17.3%

-33.6%

-17.2%

8.4%6.5%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

HFR Fund ofFunds Index

HFRComposite

Index

CSFB/TremontHF Index

CTAs HFRLong/Short

Equity Index

MSCI World(USD)

S&P 500 NA SDAQComposite

SPI (CHF) JP MorganGlobal BondIndex (USD)

Pictet (CHF)

Light colors: 1/1994-3/2000Dark colours: 4/2000-3/2003

Hedge funds preserve capital in bad times

Data: HFR, Barclay


Low cross-correlations permit efficient portfolio diversification

Data: HFR HF, Barclay CTA Indices 1994 - Aug 2007


Diversification lowers risk

The optimal number of funds seems to be between 15 and 30

However, depending on the investor‘s specific utility curve (eg single HF fall out risk) the number may be significantly higher

0%

5%

10%

15%

20%

25%

0 5 10 15 20 25 30

Number of funds/programs/stocks

Stan

dard

dev

iatio

n p.

a.

Single manager managed futures100 largest U.S. stocksSingle manager hedge funds

Data: TASS, HFR, MSCI

Note: Attrition rate of HFs is similar to attrition rate of mutual funds


The selection of the right hedge fund strategy is crucial to achieve a low correlation to stock and bond portfolios

Correlation between FoHF composite and MSCI World, JPM Global Bonds

Data: HFRI

The high correlation to the MSCI World is mostly driven by the large amount of long-biased long/short equity hedge funds (appr. 40%). Other strategies are less correlated.

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

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0.40

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1.00M

-90

M-9

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M-9

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M-0

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M-0

3

M-0

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M-0

5

M-0

6

M-0

7

12-month ro lling correlation to global stocks

12-month ro lling correlation to global bonds







Conclusions


CSFB Tremont www.hedgeindex.com Asset-weighted; 10 strategies; invested in 60 HFs

Dow Jones www.djindexes.com Equal weighted; 1 directional, 5 non-directional strategies; invested in 32 HFs

FTSE Hedge www.ftse.com Triple investibility weighted; 8 strategies; invested in 40 HFs

HFRX www.hedgefundresearch.com Equal weighted; 8 strategies; invested in 80 HFs

MSCI www.msci.com/hti Complex weighting; 8 strategies; invested in 138 HFs

Investable hedge fund indices

http://www.hedgeindex.com

http://www.djindexes.com

http://www.ftse.com

http://www.hedgefundresearch.com

http://www.msci.com/hti


Non-investable hedge fund indices

Barclay Trading www.barclaygrp.com Equal-weighted CTA-Index; 17 strategies Group (2,080 CTAs)

CSFB/Tremont www.hedgeindex.com Asset-weighted HF Index and 13 HF sub-indices (434 HFs)

Eureka Hedge www.eurekahedge.com Several industry indices

Hedge Fund www.hedgefundresearch.com Equal-weighted HFRI Index and 32 HF Research sub indices (1,700 HFs)

InvestHedge www.hedgefundintelligence.com Several industry indices

MSCI www.msbarra.com Equal-weighted and asset-weighted indices; 18 strategies (2,800 HFs)

http://www.barclaygrp.com

http://www.hedgeindex.com

http://www.eurekahedge.com

http://www.hedgefundresearch.com

http://www.hedgefundintelligence.com

http://www.msbarra.com


Funds of funds have underperformed the HF index

Data: HFR HF, Barclay CTA Indices 1994 - Aug 2007

0%

2%

4%

6%

8%

10%

12%

14%

16%

0% 5% 10% 15% 20% 25%Standard deviation pa

Ret

urn

pa

MSCI World

Macro

Distressed

CV Arb

EM

Short

Merger Arb

L/S Equity Sector

JPM

Hedge Fund Index

MN Equity

FI Arb

MBS

CTAs

FI HY Fund of Funds


Possible explanations for the perceived underperformance offunds of funds

•Fund of fund fees (average management fee of 1.25% and average performance fee of 12.5%)

•Survivorship and selection bias disregarded in hedge fund indices (estimates range from 1.0% to 4.0% pa)

•Bull market bias of hedge fund indices(40-50% of hedge funds do long/short equity)

•Poor selection, low barriers to market entry

Introduction to Hedge Funds 35Data: Harcourt, TASS, HFR, Barclay

Hedge funds are hedged and provide an asymmetric return profile

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Hedge Fund Composite Index

JPM Global Bond Index

MSCI World Index


Long term hedge fund return outlook

Hedge fund returns are a function of:

l Stock market returns

l Libor and bond rates

l Market liquidity

l Strategy alpha, ie market inefficiencies and supply/demand imbalances

Expected long term returns: Libor + 500 pa







Conclusions


Hedge funds are the perfect diversification tool for a traditional stock/bond portfolio

Addition of hedge funds to a 50% stock and 50% bond portfolio results in lower risk/higher return portfolio

Data: 1994-Aug 2007

0%

5%

10%

0% 4% 8% 12%Standard deviation pa

Ret

urn

pa

MSCI World $

JPM Global Bonds $

HFRI FoF Index


Aggressive or conservative? Trade-off of equity correlation vs returns

0%

2%

4%

6%

8%

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-0.20 0.00 0.20 0.40 0.60 0.80 1.00

Correlation to S&P 500

Net

retu

rn p

a

Data: Altvest, S&P, Jan-94 to Dec-99

Aggressive FoF“Equity surrogate“

Conservative FoF“Bond surrogate“

Fund of funds performance


There are two types of hedge fund investors

Type A:HFs as a separate

asset class

Type B: HFs as an active overlay

to a passive portfolio

• Passive Index + HFs = Active • Diversification

Two types of investors


Type A – Driven by „Core-Satellite“ investment approach

Core portfolio: PASSIVE

Major developed stock and bond markets (large caps)

Indices, ETFs, tracker funds, passive mandates

Satellite portfolio: ACTIVE

HFs, small caps, EM, high yield, PE, ABS, real estate

Active long-only mandates/funds, portable alpha/overlay, hedge funds


Type B – Driven by paradigm shift in the asset management industry

8% Passive beta

strategies 35%

10%

2%Active

alpha 15%5%

90% Active long only (beta) strategies

50%

85%

Past FuturePresent

Beta will increasingly be bought cheaply through passive instruments (ETFs, indices)

The importance of Alpha as a portfolio component will likewise increase

Data: Man Investments


Hedge fund returns – Alpha oder beta?

Traditional beta =directional risk premia:

- Stock market beta- Interest rate duration- BARRA factors- Credit spreads- Currenciesetc.

Alternative beta = Directional and demand/supply premia:

- Liquidity risks- Spread risks- Volatility and correlations- Merger deal risk- Prepayment risketc.

Structural alpha = free option due to structural advantages:

- Regulatory constraints- Structural inefficiencies- Informational barriers - Speed and size- Trend-followingetc.

Skill alpha = only few really skilled managers:

- Analysis- Portfolio mgt - Risk mgtetc.

Passive Active

The source of returns varies significantly across the different HF styles, HF strategies and HFs … and varies over time !

Hedge fund returns =Traditional betas + alternative betas + structural alpha + skill alpha

Copyright: Harcourt Research


The asset management industry of the future

⇒ Hedge funds will become mainstream

⇒ Traditional and alternative asset management industries will merge

⇒ Seggregation of the traditional value chain:

BETA exposure via low-fee index certificates,

ALPHA (and Alternative Beta) via high-fee hedge fund-like investment vehicles







Conclusions


Superior risk-adjusted returns in bear and bull markets

Low to moderate correlation to traditional asset classes

Asymmetric return distribution – downside protection

Access to some of the best talent in financial markets

Highly sophisticated, unbiased investing

Transparency and regulation improving on the back of increasing institutionalisation

=> Hedge funds belong in every diversified investment portfolio

=> Demand for hedge funds will remain high, and hedge funds willbecome mainstream

Why hedge funds ?


Disclaimer

An investment in an alternative investment carries substantial risks. The nature and extent of some of these risks differ from traditional investments in stocks and bonds. There can be no assurance that the advice or information provided above will lead to superior performance. In particular, the performance of an alternative investment may vary substantially over time. Investors bear the risk of losing all or part of their investment and thus should carefully consider the appropriateness of such investments for their portfolio. While the information containedin this document has been obtained from sources deemed reliable, no representation is made as to its accuracy or completeness, and it should not be relied on as such. Past performance is not necessarily indicative of future performance.


Contact

Harcourt Investment Consulting AGStampfenbachstrasse 48 8006 Zürich - Switzerland

Contact us:Tel: +41 (0)44 365 1000 Fax: +41 (0)44 365 1001To access Harcourt research and educational material please visit:www.harcourt.ch

http://www.harcourt.ch

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