Hedge Fund of Funds VI. 2 Portfolio View: Hedge Fund-of-Funds - - PDF document

1

VI. Hedge Fund of Funds

2

Section One: Portfolio View: Hedge Fund-of-Funds

3

Alternative investments such as hedge funds of funds are included in portfolios for a number of reasons, including: 1. Risk Reduction 2. Diversification 3. Return enhancement in light of low expected returns from bonds

Note: The Hedge Fund Research, Inc. (HFRI) Fund of Funds Index is a composite of funds that invest in multiple hedge fund managers and strategies. The database includes over 500 funds and returns are shown net of fees. Average fees for a hedge fund-of-funds manager are 1.3% in addition to underlying hedge fund managers’ management and performance-based fees. Correlations based on quarterly data. S

• urce: Ibbotson.

Why Consider Hedge Fund of Funds?

10-Year Period: 1997 - 2007 HFRI Fund

• f Funds

S&P 500 MSCI EAFE Russell 2000 Lehman Aggregate Inflation (CPI) Annualized Return 7.3% 10.48% 9.92% 10.10% 6.47% 2.68% Annualized Standard Deviation 7.0% 14.80% 15.87% 18.78% 3.92% 1.31% Correlation w/ HFRI Fund-of-Funds 1.00 0.49 0.63 0.55 0.09

• 0.01

4

Return Profile

Dat a S

• urce: Ibbot son

Rolling 3-Year Annualized Ret urns

• 20%
• 15%
• 10%
• 5%

0% 5% 10% 15% 20% 25% 30% 35% S e p

• 9

9 M a r

• S

e p

• M

a r

• 1

S e p

• 1

M a r

• 2

S e p

• 2

M a r

• 3

S e p

• 3

M a r

• 4

S e p

• 4

M a r

• 5

S e p

• 5

M a r

• 6

S e p

• 6

M a r

• 7

S e p

• 7

HFRI LB Agg S&P

Rolling 3-Year Annualized Returns

5

Risk: Monthly Return Distributions

Return Distribution (Histogram): Graphically shows the number

• f
• bservations (e.g., monthly returns)

falling within certain return intervals (e.g., 0-2% ). Example: Over the past 135 monthly periods (10+ years), the S &P 500 has had 34 monthly returns that have fallen between 0% and 2% . S&P 500:

• 85 observations > 0 (62%

)

• Monthly return range: -14.4%

to 9.8% LB Aggregate:

• 93 observations > 0 (69%

)

• Monthly return range: -3.4%

to 2.7% HFRI:

• 91 observations > 0 (67%

)

• Monthly return range: -7.5%

to 6.9%

HFRI FoF Frequency Distribution 135 monthly periods 1 3 40 73 13 4 1 10 20 30 40 50 60 70 80 90

< -10

• 10 to -

8

• 8 to -6 -6 to -4 -4 to -2 -2 to 0

0 to 2 2 to 4 4 to 6 6 to 8 8 to 10 > 10

Frequency S&P 500 Frequency Distribution 135 monthly periods 2 2 6 6 13 21 34 19 17 11 4 5 10 15 20 25 30 35 40

< -10

• 10 to -

8

• 8 to -6 -6 to -4 -4 to -2
• 2 to 0

0 to 2 2 to 4 4 to 6 6 to 8 8 to 10 > 10

Frequency LB Aggregate Frequency Distribution 135 monthly periods 2 40 85 8 10 20 30 40 50 60 70 80 90 100

< -10

• 10 to -

8

• 8 to -6 -6 to -4 -4 to -2 -2 to 0

0 to 2 2 to 4 4 to 6 6 to 8 8 to 10 > 10

Frequency 90-Day T-Bills Frequency Distribution 135 monthly periods 135 20 40 60 80 100 120 140 160

< -10

• 10 to -

8

• 8 to -6 -6 to -4 -4 to -2
• 2 to 0

0 to 2 2 to 4 4 to 6 6 to 8 8 to 10 > 10

Frequency August 1998

• 14.4%

August 1998

• 7.5%

December 1999 6.9% July 1997 2.7% July 2003

• 3.4%

March 2000 9.8%

6

Risk: Standard Deviation

Remember, standard deviation (volatility) is just one measure of risk!

Rol l ing Three-Year St andard Deviat ion 0% 5% 10% 15% 20% 25% S e p

• 2

M a r

• 3

S e p

• 3

M a r

• 4

S e p

• 4

M a r

• 5

S e p

• 5

M a r

• 6

S e p

• 6

M a r

• 7

S e p

• 7

HFRI LB Agg S&P

Rolling 3-Year Standard Deviation

7

Risk: Correlation

Correlation: The degree to which two series of investment returns tend to move up or down together over time Ranges from 1 to -1

• Correlation near 1 means

return series tend to move up and down together

• Correlation near -1 means

the return series tend to move in opposite directions

• Correlation close to 0 means

the two return streams move independently (little relationship)

• Generally, lower is better

(implies more diversification benefits)

R

• lling 3-Year C
• rrelations

(HFR I vs. Fixed Income & E quity)

• 0.6
• 0.4
• 0.2

0.2 0.4 0.6 0.8 1

S ep-00 M ar-01 S ep-01 M ar-02 S ep-02 M ar-03 S ep-03 M ar-04 S ep-04 M ar-05 S ep-05 M ar-06 S ep-06 M ar-07 S ep-07 Lehm an A ggregate Index S &P 500

Rolling 3-Year Correlations

(HFRI vs. Fixed Income & Equity)

8

Ten Year Risk and Return Profile

0.00 4.00 8.00 12.00 16.00 20.00 0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00 Volatility (Risk) Rate of Return (%) Large Cap Equity Small/Mid Cap Equity Intl Large Intl Small Emerging Mkts Core Bonds High Yield Bonds Real Estate REIT's Liq Alt/Hedge Funds Private Equity Venture Capital Timber Commodities Cash

Venture Capital: 17% Return, 88% Risk

S

• urce: Ibbot son, NCREIF, Cambridge Associat es

Historical Risk/Return

Ten Year Risk vs. Return

9

Up & Down U.S. Equity Market Environments

Up Equity Markets: Cash: $100 → $125 LB Aggregate: $100 → $132 S&P 500: $100 → $1,032 HFRI FOF: $100 → $232 Down Equity Markets: Cash: $100 → $115 LB Aggregate: $100 → $135 S&P 500: $100 → $18 HFRI FOF: $100 → $85

In dollar terms, over the past 10 years, $100 invested during each of these environments translates to …

1 Cumulat ive up (posit ive) equit y market s links 74 posit ive ret urn mont hs of t he S

&P 500 Index over t he past 120 mont hly periods (10 years).

2 Cumulat ive down (negat ive) equit y market s links 56 negat ive ret urn mont hs for t he S

&P 500 Index over t he past 120 mont hly periods (10 years).

C um ulative U p E quity M arkets

1

12% 38% 56% 132% 3% 8% 12% 32% 25% 74% 195% 932%

0% 200% 400% 600% 800% 1000% 1-Y r 3-Y r 5-Y r 10-Y r

H F R I LB A gg S &P 500 C um ulative D

• wn E

quity M arkets

2

0%

• 3%
• 1%
• 15%

2% 4% 10% 35%

• 9%
• 17%
• 30%
• 82%
• 100%
• 50%

0% 50% 100% 1-Y r 3-Y r 5-Y r 10-Y r

H F R I LB Agg S &P 500

Cumulative Up Equity Markets1 Cumulative Down Equity Markets2

10

Portfolio Efficiency

Adding hedge has increased efficiency.

100% LB Agg * Hedge proxied by HFRI Fund of Funds Index

5

• 5. 5

6

• 6. 5

7

• 7. 5

8

• 8. 5

9 5 10 15 20 Annuali zed St andar d Dev i at i on % ( Ri sk ) Annualized Return % No H edge 10% H edge 20% H edge

100% S&P 500 100% LB Agg

Efficient Frontier 10-Year Period (1997 – 2007)

11

• Recent hedge fund performance illustrates correlations to equities has been rising
• In 1994, the rolling 60-month correlation to the S

&P 500 was only 0.10, now nearly 0.60

• Tremendous growth in assets plays a significant role in the rising correlation as hedge fund managers are

finding fewer opportunities to invest in the market place

• Hedge funds performance is lagging a T-Bills + 5%

benchmark

• S

ince 1998, hedge funds underperformed a T-Bills + 5% benchmark during 65%

• f rolling 5-year periods
• Given trends in the hedge fund industry, we conclude that 3.50%

spread over cash is a reasonable conservative estimation of returns for hedge fund of funds, resulting in forecasted return of 7.50%

S

• urce: Ibbot son, PIMCO, Independent Consult ant Cooperat ive (ICC)

Hedge Fund of Funds Returns Assumption

HFRI Fund of Funds Correlation to S&P 500, Premium over T-Bills + 5% 0.00 0.20 0.40 0.60 0.80 1994 1996 1998 2000 2002 2004 2006 Correlation to S &P 500

• 6.0%
• 4.0%
• 2.0%

0.0% 2.0% 4.0% 6.0% Return Premium Rolling 60 Month Correlation Premium over T-Bills + 5%

12

Section Two: S trategy View: Hedge Fund of Funds

13

What are Hedge Funds?

Can Be Defined By:

Structure:

• Investment vehicle (on-shore, off-shore etc.)
• Terms (management & performance fees, liquidity etc.)
• Investor requirements (qualified purchaser etc.)

Strategy:

• Multiple investment strategies
• Absolute-return oriented
• Performance characteristics (return / volatility / correlation etc.)

14

Hedge Fund Strategy Risk Levels

Risk Level Expected Return

High High Low

Higher Risk Moderate Risk Lower Risk Equity Market Neutral Convertible Arbitrage Fixed Income Arbitrage Risk Arbitrage Long/ S hort Equity Distressed S ecurities Global Macro Dedicated S hort Bias Emerging Markets Managed Fut ures

15

Common Hedge Fund Strategies

• Equity Market Neutral

A strategy that attempts to capture the spread between two historically-related stocks that are now misaligned. Portfolio has no net dollar, sector or market capitalization exposure.

• Convertible Bond Arbitrage

An arbitrage based upon holding a convertible security long and selling its underlying stock short. It is a market neutral strategy in which returns should be made as the underlying stock moves up

• r down in price.
• Fixed Income Arbitrage

A spread-based strategy that aims to capture the misalignment of prices in various fixed-income securities.

• Risk Arbitrage

A strategy focused on the spread between a long position in the target and a short position in the acquirer in a merger. They may also invest in reorganizations and spin-offs.

• Long/Short Equity

A hedge style encompassing funds that invest in a portfolio of long and short stocks. Funds specialize according to geography, sector and capitalization.

16

Common Hedge Fund Strategies (cont’d)

• Distressed Securities

Directional investors who invest in companies in bankruptcy and attempt to determine the values

• f the companies as they emerge from bankruptcy. They may also be long senior debt and short

j unior securities.

• Global Macro

Wide-ranging strategy in which a manager implements a cross-border macroeconomic viewpoint through the use of foreign and domestic stocks, bonds, currencies, commodities and indexes.

• Dedicated Short Bias

Equity investors who sell short the maj ority of stocks in their portfolio.

• Emerging Markets

A directional strategy invested in both equities and debt. It is difficult to short in emerging markets.

• Managed Futures

A fundamental or model-driven strategy that attempts to determine the future price direction of various asset classes through trading patterns.

17

Hedge Fund Industry Growth

$38,910 $58,370 $95,720 $167,790 $167,360 $185,750 $256,720 $367,560 $374,770 $456,430 $490,580 $539,060 $625,554 $820,009 $972,608 $1,105,385 $1,464,526 $1,868,419

$8,463 $27,861 $36,91 8 $1 4,698 $57,407 $91 ,431 $4,406 $55,340 $23,336 $46,545 $99,436 $70,635 $73,585 $46,907 $1 26,474 $1 94,51 5 ($1 ,1 41 )

$0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 $2,000,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Assets in $ Millions Estimated Assets Net Asset Flow

S

• urce: Hedge Fund Research, Inc.

Estimated Growth of Assets and Net Asset Flow (1990 to 2007)

18

80 1 27 1 68 237 377 389 426 477 51 5 538 550 781 1 232 1 654 1 996 2221 2462

530 694 937 1,277 1,654 2,006 2,392 2,564 2,848 3,102 3,335 3,904 4,598 5,065 5,782 6,665 7,241 7,634

291

1000 2000 3000 4000 5000 6000 7000 8000 9000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Number of Funds Fund of Funds Hedge Funds S

• urce: Hedge Fund Research, Inc.

Hedge Fund Industry Growth (cont’d)

Estimated Number of Hedge Funds vs. Fund of Funds (1990 to 2007)

19

Hedge Fundamentals

• Leverage
• Liquidity
• Transparency
• Regulation
• Audit Considerations
• Operational Risk
• Expenses

20

Implementation – Direct or Fund-of-Funds?

In a Fund-of-Funds strategy, An intermediary manager aggregates capital from multiple investors and invests in a broad range of diversified hedge fund or private equity strategies.

Diversification

• A Fund-of-Funds will diversify across a number of strategies and managers reducing the

volatility of investing in a single manager or strategy.

Added Due Diligence

• The Fund-of-Funds manager adds anot her layer of analytical rigor.

Access

• Fund-of-Funds pools assets of smaller commitment investors, allowing investment funds

which normally require large asset commitments.

Fees

• A maj or drawback to investing in FoF is the double layer of fees. The FoF manager charges a

fee on top of the fees charged by each of the underlying hedge funds.

Investor Hedge Fund-of-Funds Manager Hedge Fund A Hedge Fund B Hedge Fund C

Fund-of-Fund Investing

Investor

Individual Fund Investing

Hedge Fund A Hedge Fund B Hedge Fund C

21

Hedge Funds: What Do We Look For?

Minimum Criteria:

• Low volatility (conservative)
• Diversified (multi-manager, multi-strategy)
• No leverage at fund-of-fund level

General Criteria:

• Organizational S

tability

• Alignment of Interests
• Experience
• Depth in Process (due diligence, port folio construction, and risk management)
• Verifiable Performance

22

Calendar Years Over The Last Decade

16.2%

• 5.1%

26.5% 4.1% 2.8% 1.0% 11.6% 6.9% 7.5% 10.4% 10.3% 33.4% 28.6% 21.0%

• 9.1%
• 11.9%
• 22.1%

28.7% 10.9% 4.9% 15.8% 5.5% 9.7% 8.7%

• 0.8%

11.6% 8.4% 10.3% 4.1% 4.3% 2.4% 4.3% 7.0%

• 30.0%
• 20.0%
• 10.0%

0.0% 10.0% 20.0% 30.0% 40.0% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Total Rate of Return HFRI Fund-of-Funds Index S&P 500 Index Lehman Brothers Aggregate Index

Annual Performance

Calendar Year Performance Over Past Decade

23

Note: Correlation assumptions are based on history. The history used to calculate correlation is the common date range between the pair of asset classes. Correlation is calculated using quarterly returns. Data starts from 3Q 1945. S

• urce: Wurt s & Associat es Capit al Market Expect at ions, January 2008

Correlation Matrix

Large Cap US Equity Small/Mid Cap US Equity Intl Large Intl Small Emerging Markets US Core Fixed Income TIPS High Yield Fixed Income Real Estate REITs Liquid Alts/ Hedge Funds Private Equity/ VC Timber Commodi ties Cash US Inflation Large Cap US Equity 1.00 Small/Mid Cap US Equity 0.81 1.00 Intl Large 0.79 0.70 1.00 Intl Small 0.64 0.64 0.88 1.00 Emerging Markets 0.68 0.68 0.74 0.78 1.00 US Core Fixed Income 0.05

• 0.04
• 0.04
• 0.06
• 0.08

1.00 TIPS

• 0.14
• 0.15
• 0.11

0.02

• 0.14

0.45 1.00 High Yield Fixed Income 0.48 0.50 0.38 0.44 0.38 0.20

• 0.01

1.00 Real Estate 0.09

• 0.04

0.00 0.09

• 0.10

0.04 0.11 0.18 1.00 REITs 0.39 0.56 0.38 0.30 0.34 0.17 0.17 0.02

• 0.10

1.00 Liquid Alts/Hedge Funds 0.55 0.58 0.60 0.62 0.69 0.06 0.02

• 0.02
• 0.11

0.30 1.00 Private Equity/VC 0.65 0.55 0.52 0.42 0.43

• 0.22

0.15 0.05 0.17 0.21 0.55 1.00 Timber 0.11 0.06 0.12 0.00

• 0.05

0.02 0.12

• 0.01

0.29

• 0.01

0.20 0.39 1.00 Commodities 0.04 0.19 0.19 0.30 0.25 0.06 0.18 0.20 0.00 0.10 0.29 0.03

• 0.10

1.00 Cash 0.05

• 0.08
• 0.13
• 0.14
• 0.10

0.67 0.06

• 0.07

0.33

• 0.09

0.03 0.00 0.03

• 0.01

1.00 US Inflation

• 0.11
• 0.19
• 0.20
• 0.05
• 0.10
• 0.12

0.03

• 0.01

0.11

• 0.20
• 0.04
• 0.09
• 0.20

0.20 0.07 0.00

24

Hedge Funds: Advantages & Disadvantages

Advantages:

• Consistent risk adj usted returns
• Lower volatility than long-only

strategies

• Excellent diversifier because of low

correlation with both bond and equity markets

• Can choose from a variety of risk and

return profiles ranging from enhanced cash to very aggressive

• General Partner interests are closely

aligned with that of investors (performance based fee schedules and significant co-investments)

• Investment strategies are usually more

nimble (see disadvantage as well)

• Ability to pick investment strategies

that will help focus the portfolio to match the needs of the institution (vs. lack of customization in HFOF)

Disadvantages:

• Identifying highly skilled mangers can be

difficult and gaining access even more difficult

• Capacity becomes an issue for different

strategies at different times

• Liquidity and Regulatory Risks (less

regulation, longer lock-ups)

• Lack of transparency
• Many, are small businesses with short

track records (business risk)

• They often use exotic investment

strategies and success is often more dependent on the brilliance of individuals than a “ process” . (Key person risk, process not repeatable)

• “ Nimble” managers may style-drift

significantly, making portfolio risk management difficult.

• Audit requirements are higher than with

traditional investments

25

Hedge Fund-of-Funds: Advantages & Disadvantages

Advantages:

• Provides strategy and manager

diversification with a relatively small investment.

• Access to the best talent, even if

individual hedge funds have minimums that are prohibitively high for single investors.

• Lowers total portfolio volatility and

increases risk-adj usted returns.

• Provides strategic asset allocation

among hedge fund styles.

• Reduces exposure risk of a single hedge

fund manager “ blow-up.”

• Due diligence on individual hedge funds

is exhaustive, time-consuming and can be costly.

Disadvantages:

• This form of entry into the alternative

investment asset class has experienced explosive growth in recent years.

• Returns have trended downward as

assets have increased.

• Fund-of-funds programs charge an

additional layer of fees – 1%

• 2%

.

• Limited liquidity (quarterly or annual)

with advanced notice (90 days).

• Lock-ups may last up to a year.
• Audit requirements are higher than with

traditional investments