L1: Hedge Fund Overview 1.What is a hedge fund? 2.How do hedge funds work? 3.Statistics of the...

L1: Hedge Fund Overview1. What is a hedge fund?2. How do hedge funds work?3. Statistics of the Industry4. Academic research on hedge fund performance5. Hedge fund performance in 20086. Why to invest in a fund of funds?

L1: Hedge Fund Overview 1

Hedge funds A hedge fund is an investment fund that can undertake a wider range of

investment and trading activities than other funds, but which is generally only open to certain types of investor specified by regulators. These investors are typically institutions, such as pension funds, university endowments and foundations, or high net worth individuals, who are considered to have the knowledge or resources to understand the nature of the funds.

Hedge funds focus on absolute returns, different from mutual funds. Many hedge funds don’t use hedging.

As a class, hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on public markets. They also employ a wide variety of investment strategies, and make use of techniques such as short selling and leverage.o Relative value/arbitrageo Event-driveno Macroo Equity hedge

L1: Hedge Fund Overview


For more info, see http://en.wikipedia.org/wiki/List_of_hedge_funds.

Note 1: As of December 31, 2008. All other figures as of January 1, 2009.Note 2: Tied for 10th place.Source: Absolute Return Billion Dollar Club, March 2009 rankings

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

Firm Region AUM ($bn)Bridgewater Associates U.S. 38.6J.P. Morgan U.S. 32.9Paulson & Co. U.S. 29.0D.E. Shaw Group U.S. 28.6Brevan Howard1 Europe 26.8Och-Ziff Capital Management U.S. 22.1Man AHL1 Europe 22.0Soros Fund Management U.S. 21.0Goldman Sachs Asset Management1 U.S. 20.6Farallon Capital Management2 U.S. 20.0Renaissance Technologies2 U.S. 20.0


How Hedge Fund Leverage Works

Hedge fund investor capital can be leveraged in several ways to enhance overall returns.

Direct forms of leverage:

Bank borrowings

Hedge funds can take out margin loans (buying securities on margin) from banks. For example, assuming a 20% margin on security ABC, a hedge fund could buy $10 worth of securities by paying only $2 upfront and having the bank supply the remaining $8 in the form of a loan. To protect its loan balance, the bank requires the hedge fund to deposit an agreed amount of securities as collateral. If the market value of the ABC securities drops, the bank can require 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 one party agreeing to sell a security to another party for a given price and then buying it back later at a higher price.

4


How Hedge Fund Leverage Works

Implicit forms of leverage:

Short selling

Short selling is the practice of selling securities borrowed from banks or other counterparties. Funds raised from the sale of these borrowed securities are used to buy other securities – a practice 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 risk exposures to an asset class through the use of derivatives than from buying the assets directly. Investments in the high-risk portions of structured products such as collateralized debt obligations (CDOs) also provide implicit leverage.

Through the first half of 2008, total hedge fund industry leverage was estimated to be three to four times investor capital.


Note 1: Includes leverage from debt and off-balance sheet leverage through derivatives and other instrumentsNote 2: Leverage ratio = (total leverage + AUM) / AUMSource: McKinsey Global Institute; Global Capital Markets Survey; Dresdner Kleinwort Equity Research; International Financial Services, London; Financial Risk Management, Ltd.; Financial Services Authority

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

Hedge Funds’ Leveraged Assets Fell from $6.6 Trillion to $2.4 Trillion in Less Than a One-Year Period

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 1.20.4 0.6

0.81.3 0.8

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 positionsLeverage through debtAssets under management

Hedge Fund Growth

Hedge funds grew at a remarkable rate between 1990 and 2007, from 530 funds with under $39 billion in assets to more than 7,600 funds with assets of almost $1.9 trillion. Underlying factors

Diversification Absolute returns Increased institutional investing Favorable market environment Human capital growth Financial innovation



Estimated Total Number of Hedge Funds and Fund of Funds

1990 – 20008

610 821 1,1051,514

1,9452,3832,7812,990

3,3253,6173,873

4,4545,379

6,297

7,436

8,6619,462

10,0969,176

0

2,000

4,000

6,000

8,000

10,000

12,000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08


Fund of funds: A "fund of funds" (FOF) is an investment strategy of holding a portfolio of other investment funds rather than investing directly in stocks, bonds or other securities. This type of investing is often referred to as multi-manager investment. A fund of funds may be 'fettered', meaning that it invests only in funds managed by the same investment company, or 'unfettered', meaning that it can invest in external funds.

Estimated Total Number of Hedge Funds –versus– Fund of Funds

1990 – 20008

80 127 168 237 291 377 389 426 477 515 538 550 7811,232

1,6541,996 2,221

2,4622,368

530 694 9371,277

1,6542,0062,392

2,5642,8483,102 3,335

3,9044,598

5,0655,782

6,6657,241

7,634

6,808

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 08

Fund of Funds

Hedge Funds


Estimated Growth of Assets

Hedge Fund Industry 1990 – 2008, $ 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 08


Source: Hedge Fund Research, Inc.

Estimated Growth of Assets

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 08


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

Composition of Investors: Share of High Net Worth Individuals Has Fallen

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 individualsFund of hedge funds

Endowments and foundationsCorporations and institutionsPension funds


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

Hedge Fund Revenues are Highly Concentrated in the Top 205 Funds

43%

18%

13%

26%

Hedge Fund Revenue Pool for 2006

>$5bn (64 funds)

$3-5 bn (64 funds)

$2-3 bn (77 funds)

<$2 bn (5,000+ funds)

74% of revenues are concentrated in the 205 largest funds based on AUM74% of revenues are concentrated in the 205 largest funds based on AUM

205 funds

Hedge Fund Performance

Average annual return by hedge funds between 1996 and 2006 was only slightly higher than broad equity market return in this periodo Hedge fund research’s HFRI fund weighted composite index (HFR index) show

average annual return of 10.6% in the period, relative 8.1% for MSCI-World equity index

o -5% during 2007 and 08 and -20% for MSCIo MSCI Inc. is a leading provider of investment decision support tools to

investment institutions. Products include indices, portfolio risk, and performance analytics - for use in managing equity, fixed income and multi-asset class portfolios - and governance tools. http://www.msci.com/#

The standard deviation of return of hedge funds is lower in the same periodo 2.1% for HFRI and 4.2% for MSCI

Caveat: reporting biases



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

Hedge Fund Returns are Especially Strong in Bull Markets

Monthly Hedge Fund Returns, 1994 – 2008HFRI 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

Jun-

08

Dec

-08

Monthly Hedge Fund Returns, 1994 – 2008HFRI Fund Weighted Composite Index


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

Annualized Total Return, %

Comparison of Hedge Fund Returns to the S&P 500 Index’s Returns, 2000 – 2008

4.9% 4.4% 3.0%

15.4%9.6%

7.6%

13.9%12.6%

-19.1%

-10.1%-13.0%

-23.4%

26.4%

9.0%

3.0%

13.6%

3.5%

-38.5%

2000 2001 2002 2003 2004 2005 2006 2007 2008

Hedge funds

S&P 500


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

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

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

Ave

rage

Ret

urn

%

Portfolio composition:100% equities, 0% bonds

Additional 5% bonds, moving to the left0% equities, 100% bonds

Alternative Strategies

Equity-Based Strategies: equity long-short or non-hedged equity Macro strategies

o Global macroo Emerging markets

Arbitrage strategies/relative value strategieso Fixed income based arbitrageo Convertible arbitrageo Relative value arbitrage: pair trading (two companies that are competitors in

the same industry that have stocks with a strong historical correlation in daily stock price movements)

Event-driven strategieso Activisto Merger arbitrage/risk arbitrageo Distressed securities



Note 1: Quartiles are defined based on risk-adjusted performance, defined using fund Sharpe ratio between 2001 and 2007. The Sharpe ratio is given by Average (R – Rf) / Standard Deviation (R), where R is the return and the benchmark rate Rf is the S&P 500 average between 2001 and 2007 (2.43%).Source: McKinsey Global Institute; Hedge Fund Research, Inc.

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

Average annual returns (net of fees) by strategy for risk-adjusted quartiles, 2001 – 2007, %

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&P 500Lehman US Aggregate Bond Index


Academic Research on Hedge Fund Performance

Due to limitations in the availability of hedge fund performance data, a clear assessment of industry performance is difficult to obtain. However, based on what is available through the small but growing 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 indices.1

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), based on data 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 create a number of biases:


Academic Research on Hedge Fund Performance

Selection bias: participation in hedge fund databases is voluntary.

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 registration are provided and incorporated into the database as well. Funds are typically included in databases 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 survivorship and backfill bias together can inflate industry returns by as much as 4%.5


Travails of the Hedge Fund Market in 2008

Hedge funds are supposed to thrive in rough markets.

Not in 2008. A historic decline in stocks, and troubles in almost every part of the bond market, dealt hedge funds their worst year on record. By the end of the year, investors were scrambling to get out, 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 Fund Research, 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 gains most funds posted for more than a decade. The biggest fund category within hedge funds, long-short 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 the year, 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: Too many funds bought the same assets. As markets fell in September and October, and hedge funds came under pressure, many moved to sell investments, sending prices even lower and causing losses for other funds that hadn't yet sold.

Stocks favored by hedge funds performed even worse than the overall market, according to data from Goldman Sachs. An index of 50 stocks "that matter most" to hedge funds lost nearly 45%, including 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 loans, real-estate holdings, and stakes in small, private companies. These illiquid investments at one time accounted for 20% of some fund portfolios, estimated to total about $400 billion. As financial markets 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 2008’s arrest of Bernard Madoff for a $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 Island, as 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 clients to invest in a portfolio of other investment funds. Several such firms channeled billions of dollars to Madoff through feeder funds, raising questions about how much due diligence those firms performed and whether clients' investments are as diversified and safe as they should be.


Source: McKinsey Global Institute; NYSE; LSE; U.S. Bond Market Association; IMF; Greenwich Associates; Financial News; Gartmore; Stern School of Business; British Bankers’ Association; ISDA; McKinsey CIB practice

Hedge Funds Account for a Significant Share of Trading Volume

Hedge Fund’s Estimated Share of Trading, %

32

47

45

30

60

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

Lock-ups, gates, and Side Pockets

Lock-up: A lock-up provision provides that during an initial investment period of 1 to 2 years, an investor is not allowed to withdraw any money from the fund. It is a way to prevent invested capital from being withdrawn during certain periods of time

Gate: a restriction that limits the amount of withdrawals during a quarterly or semiannual redemption period after the lock-up period expires. A gate of 10% to 20% is common. A gate allows the hedge fund to increase exposure to illiquid assets without facing a liquidity crisis.

A side-pocket account: to store comparatively illiquid or hard-to-value assets. o Once an asset is designed for inclusion in a side pocket, new investors don’t participate in the

returns from this asset.o Sometimes, hedge funds were accused to put distressed assets into a side pocket.


Hedge Fund Illiquid Investments

Hedge funds typically limited their investment in illiquid investments, preferring to match their investment horizon to the typically 1 year lock-up period that their investors agree to.

Many hedge funds have increasingly invested in illiquid assets in an effort to augment returno Participated in CDOs and CLOso Invest in loans



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

Gating

The illiquidity of hedge funds often means that, even if investors realize the manager of their fund has run into trouble, it could be months before they can get their money back. Even then, arrangements called “gates” may restrict the proportion of an investor’s holdings that can be redeemed. Hedge fund managers use gates to control redemptions during difficult markets. For example, in the throes of the subprime mortgage meltdown of 2007, an article in the New York Times blog “DealBook” described 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 best long term results for our investors […] we don’t believe it is prudent or in the interest of our investors to sell assets in the current market environment.” The ability of the Bear Stearns hedge fund managers to suspend investor redemptions illustrates the power of gating. Because the fund had incurred serious losses, investors in the fund likely would have pulled their money out were they not bound by gates. Thus, gating allows hedge fund managers to have greater control over their investors’ funds by preventing investors from obtaining redemptions at inopportune times.

Hedge Fund IPOs

IPOs by management companies Man Group PLC launched the first hedge fund IPO in 1994 Fortress Investment Group (FIG) went public in 2007 GLG Partners launched an IPO in 2007, raised $3.4 billion Och-Ziff launched an IPO in 2007Hedge fund bond issues Citadel filed a registration statement with the SEC to enable a public

bond offering in December 2007, selling $500 million bond to institutional investors.



Recent Hedge Fund IPOs Have Underperformed the Broader Market

Fortress Investment Group (NYSE:FIG) versus the S&P 500 IndexFebruary 9, 2007 (IPO date) to December 31, 2008

-120%

-100%

-80%

-60%

-40%

-20%

0%

20%

Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08

FIG S&P 500


Source: Data provided by Commodity Systems Inc.

Recent Hedge Fund IPOs Have Underperformed the Broader Market

Och-Ziff Capital Management Group LLC (NYSE:OZM) versus the S&P 500 IndexNovember 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 Dec-08

OZM S&P 500


Source: Grosvenor Capital Management

Why Use a Fund of Funds Firm?

Diversification and accesso Immediate diversification with relatively modest capital investmento Access to certain managers who might otherwise be closed for investment

Value-added investment processo Fundamental knowledge of many different investment strategieso Network of industry relationships assists in filtering manager universeo Staffing resources and expertise necessary for manager due diligence and monitoringo Understanding of quantitative and qualitative portfolio construction issueso Dynamic process that requires constant attention

Operational efficiencieso Legal due diligence and document negotiationo Consolidated accounting, performance and financial reportingo Cash flow management

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