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

1 Hedge Fund of Funds VI.

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

Why Consider Hedge Fund of Funds? 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 10-Year Period: 1997 - 2007 HFRI Fund Russell Lehman Inflation of Funds S&P 500 MSCI EAFE 2000 Aggregate (CPI) Annualized Return 7.3% 10.48% 9.92% 10.10% 6.47% 2.68% Annualized 7.0% 14.80% 15.87% 18.78% 3.92% 1.31% Standard Deviation Correlation 1.00 0.49 0.63 0.55 0.09 -0.01 w/ HFRI Fund-of-Funds 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 ource: Ibbotson. 3

Return Profile Rolling 3-Year Annualized Returns Rolling 3-Year Annualized Ret urns 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% 9 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 - - - - - - - - - - - - - - - - - p p p p p p p p p r r r r r r r r a a a a a a a a e e e e e e e e e S M S M S M S M S M S M S M S M S HFRI LB Agg S&P Dat a S ource: Ibbot son 4

Risk: Monthly Return Distributions Return Distribution (Histogram): S&P 500 Frequency Distribution LB Aggregate Frequency Distribution 135 monthly periods 135 monthly periods Graphically shows the number of 100 40 observations (e.g., monthly returns) 85 34 90 35 falling within certain return intervals 80 30 (e.g., 0-2% ). Example: Over the past August 70 March 25 21 135 monthly periods (10+ years), the 1998 60 2000 19 17 20 -14.4% 9.8% 50 S &P 500 has had 34 monthly returns 40 July July 13 40 15 11 that have fallen between 0% and 2% . 1997 2003 30 10 6 6 2.7% -3.4% 4 20 2 2 5 8 S&P 500: 0 10 2 0 0 • 85 observations > 0 (62% ) < -10 -10 to - -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 < -10 -10 to - -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 8 • Monthly return range: -14.4% to 9.8% 8 Frequency Frequency LB Aggregate: HFRI FoF Frequency Distribution 90-Day T-Bills Frequency Distribution • 93 observations > 0 (69% ) 135 monthly periods 135 monthly periods • Monthly return range: -3.4% to 2.7% 160 90 135 140 80 73 HFRI: 70 120 • 91 observations > 0 (67% ) 60 100 December August 50 • Monthly return range: -7.5% to 6.9% 80 40 1999 1998 40 60 6.9% -7.5% 30 40 20 13 20 4 10 3 1 1 0 0 < -10 -10 to - -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 < -10 -10 to - -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 8 8 Frequency Frequency 5

Risk: Standard Deviation Rolling 3-Year Standard Deviation Rol l ing Three-Year St andard Deviat ion 25% 20% 15% 10% 5% 0% 3 4 5 6 7 2 3 4 5 6 7 0 0 0 0 0 0 0 0 0 0 0 - - - - - - - - - - - r r r r r p p p p p p a a a a a e e e e e e M M M M M S S S S S S HFRI LB Agg S&P Remember, standard deviation (volatility) is just one measure of risk! 6

Risk: Correlation Correlation: Rolling 3-Year Correlations R olling 3-Year C orrelations (HFRI vs. Fixed Income & Equity) (HFR I vs. Fixed Income & E quity ) The degree to which two 1 series of investment returns tend to move up or down together over time 0.8 Ranges from 1 to -1 0.6 • Correlation near 1 means 0.4 return series tend to move up and down together 0.2 • Correlation near -1 means the return series tend to move 0 in opposite directions -0.2 • Correlation close to 0 means the two return streams move independently (little -0.4 relationship) -0.6 • Generally, lower is better 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 (implies more diversification Lehm an A ggregate Index S &P 500 benefits) 7

Historical Risk/Return Ten Year Risk vs. Return Rate of Return (%) Ten Year Risk and Return Profile 20.00 Venture Capital: 17% Return, 88% Risk 16.00 12.00 8.00 4.00 0.00 0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00 Volatility (Risk) 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 S ource: Ibbot son, NCREIF, Cambridge Associat es 8

Up & Down U.S. Equity Market Environments 2 1 Cumulative Up Equity Markets 1 Cumulative Down Equity Markets 2 C um ulative U p E quity M arkets C um ulative D own E quity M arkets 100% 1000% 932% 800% 35% 50% 600% 10% 4% 2% 0% -1% 0% 400% -3% 195% -9% -15% 132% -17% 200% 74% 56% -50% -30% 38% 25% 32% 12% 8% 12% 3% -82% 0% -100% 1-Y r 3-Y r 5-Y r 10-Y r 1-Y r 3-Y r 5-Y r 10-Y r H F R I LB Agg S &P 500 H F R I LB A gg S &P 500 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). In dollar terms, over the past 10 years, $100 invested during each of these environments translates to … Up Equity Markets: Down Equity Markets : Cash: $100 → $125 Cash: $100 → $115 LB Aggregate: $100 → $132 LB Aggregate: $100 → $135 S&P 500: $100 → $1,032 S&P 500: $100 → $18 HFRI FOF: $100 → $232 HFRI FOF: $100 → $85 9

Portfolio Efficiency Efficient Frontier 10-Year Period (1997 – 2007) 9 8. 5 8 100% S&P 500 Annualized Return % 7. 5 7 No H edge 6. 5 10% H edge 20% H edge 100% LB Agg 6 100% LB Agg 5. 5 5 0 5 10 15 20 Annuali zed St andar d Dev i at i on % ( Ri sk ) * Hedge proxied by HFRI Fund of Funds Index Adding hedge has increased efficiency. 10

Hedge Fund of Funds Returns Assumption • 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% of 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% HFRI Fund of Funds Correlation to S&P 500, Premium over T-Bills + 5% 0.80 6.0% 4.0% &P 500 0.60 Return Premium 2.0% Correlation to S 0.0% 0.40 -2.0% 0.20 -4.0% 0.00 -6.0% 1994 1996 1998 2000 2002 2004 2006 Rolling 60 Month Correlation Premium over T-Bills + 5% S ource: Ibbot son, PIMCO, Independent Consult ant Cooperat ive (ICC) 11

12 trategy View: Hedge Fund of Funds S Section Two:

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.) 13

Hedge Fund Strategy Risk Levels High Higher Global Macro Risk Expected Return Dedicated S hort Bias Emerging Markets Managed Fut ures Moderate Long/ S hort Equity Risk Distressed S ecurities Lower Equity Market Neutral Risk Convertible Arbitrage Fixed Income Arbitrage Risk Arbitrage Low High Risk Level 14

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 or 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. 15