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Hedge Fund Strategies as an integral part of a diversified portfolio

Hedge Fund Strategies as an integral part of a diversified portfolio. Haus- farben. Zusatz- farben. SCG …. B 1 …. Swiss Capital Alternative Investments AG. B 2 …. R 2 …. B 3 …. G 1 …. B 4 …. G 2 …. B 5 …. G 3 …. B 6 …. G 4 …. S 1 …. G 5 …. S 2 …. G 6 …. S 3 ….

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Hedge Fund Strategies as an integral part of a diversified portfolio

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  1. Hedge Fund Strategies as an integral part of adiversified portfolio Haus- farben Zusatz- farben • SCG • … • B 1 • … Swiss Capital Alternative Investments AG • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. 18th October 2005 • G 2 • … • G 3 • …

  2. Haus- farben Zusatz- farben • SCG • … • B 1 • … Agenda • B 2 • … • R 2 • … • Part 1: Sources of value in alternative strategiesPart 2: Overview of different hedge fund strategies Part 3: Integration of fund of hedge funds in traditional portfolio • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  3. Hedge funds have greater flexibility to implement different trading strategies by using a broader choice of financial instruments • Hedge funds can exploit opportunities created by financial markets volatility; free from benchmark constraints, they can go long or short, leverage up or hold cash when market condition changes. • Better risk return profile and capital preservation, especially for long term investors. Cash low <5% Govt.Bonds Corp. Bonds Real Estate high >10% Equity Com-modity Haus- farben Zusatz- farben • SCG • … • B 1 • … What is a hedge fund? • B 2 • … • R 2 • … Negative„Short“ Beta<0 Market „Neutral“ Beta=0 Positive„Long“Βeta>0 • B 3 • … • G 1 • … • B 4 • … • G 2 • … „Long only“ Universe • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … Hedge Fund Volatility 5-10% • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  4. Static / buy-and-hold Profit • Traditional asset management Price % Loss • Dynamic exposuremanagement • Dynamic exposuremanagement and exploiting of market inefficiencies • Non-traditional / traditional asset management • Non-traditional asset management Profit Price % Loss Profit Price % Loss Haus- farben Zusatz- farben • SCG • … • B 1 • … Different investment approach leads to different payoffs • B 2 • … • R 2 • … Investment Approach Payoff Applied by: • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  5. HFRI HSI Haus- farben Zusatz- farben • SCG • … • B 1 • … Value provided by hedge funds • B 2 • … • R 2 • … • B 3 • … • G 1 • … • Higher Sharpe ratio • Reduce traditional portfolio sensitivity to market exposure, e.g. interest rate, equity, etc. • Reduce drawdown risk • Provides access to profitable trades otherwise not accessible to investors • Merger arbitrage • Distressed • Systematic trading • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … HFRI: Hedge Fund Research Index (Composite)

  6. Growth Volatility Return Differential Top Performers Bottom Performers Long-biased Funds Opportunistic Funds Market Neutral Funds Investing in a growth industry through a diversified portfolio. Long undervalued stocks and short overvalued stocks minimise market and sector exposure. Constructing portfolios with flexible exposure; extract value from volatility. Haus- farben Zusatz- farben • SCG • … • B 1 • … Source of value: exposure management (e.g. long/short equity strategy) • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … Source of Return • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … Fund Strategy • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  7. Haus- farben Zusatz- farben • SCG • … • B 1 • … Exposure management: Example from SC Long/Short Equity Fund • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG

  8. Haus- farben Zusatz- farben • SCG • … • B 1 • … On-going monitoring: Example from SC Long/Short Equity Fund • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG

  9. low <5% high >10% Haus- farben Zusatz- farben • SCG • … • B 1 • … Where is our sample fund positioned in the Risk Matrix? • B 2 • … • R 2 • … Negative„Short“ Beta<0 Market „Neutral“ Beta=0 Positive„Long“Βeta>0 • B 3 • … • G 1 • … • B 4 • … • G 2 • … • Opportunistic fund positioned: • market neutral • net long • net short • Higher volatility • B 5 • … • G 3 • … • B 6 • … • G 4 • … Volatility 5-10 • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … Sample fund • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG

  10. Haus- farben Zusatz- farben • SCG • … • B 1 • … Different types of single Long/Short Equity Funds • B 2 • … • R 2 • … • B 3 • … • G 1 • … Short Bias Long Bias • B 4 • … • G 2 • … Market Neutral Opportunistic • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG

  11. Convertible Bond = Pricing defined by How to offset exposure Embedded optionality • Stock price • Volatility • Additional optionality • Short stocks • Short options (volatility) Bond • Interest rates • Credit spread • Interest rate swap • Credit default swap Haus- farben Zusatz- farben • SCG • … • B 1 • … Source of value: market inefficiencies (e.g. convertible arbitrage strategy) • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • Typical strategies • Long convertible bond and short the underlying stock • Dispersion trade by being long the volatility through the convertible bond position and short index volatility through index options • Convertible stripping to eliminate credit risk • Buying distressed convertible bonds and hedging by selling short the underlying equity • Arbitraging pricing inefficiencies of complicated convertible bonds (mandatory conversion, conversion factors based on future dividend payments, etc.) • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  12. Return drivers • Inefficiency in option market • Dynamic hedging, i.e. „gamma trading“ • Narrowing credit spreads • Under or over-hedging of interest rate risk • Risk • Gamma; e.g. changing delta in extreme market situation • Credit events • Unexpected occurrence of „additional optionality“ • Liquidity risk • Availability of stock borrowing Haus- farben Zusatz- farben • SCG • … • B 1 • … Source of value: market inefficiencies (e.g. convertible arbitrage strategy) • B 2 • … • R 2 • … Convertible Bond = Pricing defined by How to offset exposure • B 3 • … • G 1 • … Embedded optionality • Stock price • Volatility • Additional optionality • Short stocks • Short options (volatility) • B 4 • … • G 2 • … • B 5 • … • G 3 • … Bond • Interest rates • Credit spread • Interest rate swap • Credit default swap • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  13. Performance of Convertible Arbitrage in different market cycles

  14. Haus- farben Zusatz- farben • SCG • … • B 1 • … Wrap-up part 1 • B 2 • … • R 2 • … • Non-traditional management approaches result in option asymmetric/option like payoff profiles • Dynamic exposure management and exploitation of market inefficiencies are the main source/basis of value added by Hedge Funds • Arbitrage strategies deliver in a normal market environment steady returns with low volatility; market dislocations can increase the volatility profile on a temporary basis though • Hedge Fund managers apply a lot of different investment technics; sometimes “cross-border” and hence are not always easy to “put in a box” • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • Topics in part 2 • Other Hedge Fund strategies • How to classify different Hedge Fund strategies • Statistical/quantitative characteristics • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  15. Haus- farben Zusatz- farben • SCG • … • B 1 • … Agenda • B 2 • … • R 2 • … • Part 1: Sources of Value in alternative strategiesPart 2: Overview of different hedge fund strategies Part 3: Integration of hedge fund of funds in traditional Portfolios • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  16. Description Return Drivers Risks • Fixed Income Arbitrage • Exploit current or expected temporary price imbalances • Mainly in liquid markets • Complexity due to many variables (yield curves, convexity, liquidity, volatility) • Interest rate direction trends • Interest rate volatility • Economic changes • Structural changes (Euro convergence) • Liquid markets • Flight to quality situations • High leverage • Fixed income prices become increasingly efficient Distressed Investing • purchase securities, particularly debt instruments, of companies in financial distress, bankruptcy, or restructuring • Employ a wide range of securities along the capital structure • Different approaches from passive buy-and-hold to active involvement (activists) • Appreciation of distressed securities due to successful reorganisation or other exit strategies • Market inefficiencies (e.g. information advantage) • Manager experience and know-how • Extremely difficult to evaluate • General widening of credit spreads • Mark-to-market fluctuations • Liquidity risk Haus- farben Zusatz- farben • SCG • … • B 1 • … Other hedge fund strategies (1/2) • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  17. Description Return Drivers Risks • CTA / ManagedFutures • Trading using trend following computer program • Market trends • Volatility • Lack of clear trends in the market • Rapid, intra-session price reversals • Low market liquidity • Increased transaction costs • High dependency on soundness of model Global Macro • Investment restriction the least restricted • Trading based on fundamental macroeconomic views • Across multiple asset classes and markets • Predictable macro- economic picture • Manager-specific risk Haus- farben Zusatz- farben • SCG • … • B 1 • … Other Hedge Fund strategies (2/2) • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  18. Haus- farben Zusatz- farben • SCG • … • B 1 • … CTA: Simplified Example • B 2 • … • R 2 • … CTA strategies are based on simple rules: • B 3 • … • G 1 • … The logic of this strategy is: • The market has a “downtrend” if the slow indicator (15 day moving average) is higher than the fast indicator (5 day moving average) • The market has an “uptrend” if the slow indicator (15 day moving average) is lower than the fast indicator (5 day moving average) Start If (15 day moving average > 5 day moving average) Sell 1 contract @ open End If (15 day moving average < 5 day moving average) Buy 1 contract @ open End End • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  19. 6000 80% 5 day moving average 15 day moving average 70% DAX cumulative return 5000 60% 50% 4000 40% DAX 30% Cumulative retrun 3000 20% 10% 2000 0% -10% 1000 -20% 1/2/2004 6/8/2004 7/6/2004 8/3/2004 1/16/2004 1/30/2004 2/13/2004 2/27/2004 3/12/2004 3/26/2004 4/13/2004 4/27/2004 5/11/2004 5/25/2004 6/22/2004 7/20/2004 8/17/2004 8/31/2004 Haus- farben Zusatz- farben • SCG • … • B 1 • … Our model in a trendless market: 2004 • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG

  20. 6000 80% 5 day moving average 15 day moving average 70% DAX Cumulative Return 5000 60% 50% 4000 40% DAX 30% Cumulative Return 3000 20% 10% 2000 0% -10% 1000 -20% 8/2/2001 7/19/2001 8/16/2001 8/30/2001 9/13/2001 9/27/2001 10/11/2001 10/25/2001 Our model with market trend and market correction (September 2001) Source: Swiss Capital Alternative Investments AG

  21. Hedge Fund Strategies: Exposure to Risk Factors

  22. Haus- farben Zusatz- farben • SCG • … • B 1 • … Hedge fund Managers: Other Risks • B 2 • … • R 2 • … • Manager style style drift, performance and volatility consistent with strategy objectives, reaction to market shocks, sustainable edge • Market risk stock market beta, interest rate duration, credit spreads, correlations, volatilities, capacity risk • Credit risk leveraged levels and monitor amplification effect, credit mitigants in swaps and derivatives, exposure limits, margin call • Liquidity risk mark-to-market risk, redemption risk • Companyrisk capacity issues related to management, human resources and infrastructure when asset under management grows, „key people“ risks, segregation of duties • Operational risk back office risk (settlement , valuation, bank reconciliations for irregular or outstanding items), pricing procedures and review completeness and existence of all securities, infrastructure adequacy and disaster recovery • Legal risk Anti-money laundering policies and procedures, client litigation, conflict of interest, regulations, soft dollars and best execution • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  23. Arbitrage Directional Long/Short Equity Relative value Credit Long/ShortGlobal Equity Global Macro Long/ShortRegional Equity Managed Futures Fixed Income Arbitrage Long/ShortSector Equity Convertible Arbitrage Merger Arbitrage Equity Market Neutral Distressed Securities Haus- farben Zusatz- farben • SCG • … • B 1 • … Classification of Hedge Fund Strategies • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  24. Haus- farben Zusatz- farben • SCG • … • B 1 • … Hedge fund strategies and their properties (Jan 1990 – Jun 2005) • B 2 • … • R 2 • … • Traditional asset classes show homogeneous statistics and quantitative characteristics; not so for hedge funds: • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • Arbitrage strategies (relative value credit) • Directional strategies (long/short equity, CTA and macro) • Heterogeneous quantitative and statistical properties result in a challenge for portfolio construction and the allocation of hedge fund strategies in the portfolio context • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  25. „Arbitrage“ cluster „Long/Short Equity“ cluster „Directional“ cluster Haus- farben Zusatz- farben • SCG • … • B 1 • … Hedge Fund Strategies Clusters • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG Comment: The chart shows the rolling average returns and standard deviations for two year periods between January 1990 and March 2004

  26. Arbitrage cluster Bond cluster Haus- farben Zusatz- farben • SCG • … • B 1 • … Arbitrage Strategies versus Bonds • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG Comment: The chart shows the rolling average returns and standard deviations for two year periods between January 1990 and March 2004

  27. Haus- farben Zusatz- farben • SCG • … • B 1 • … Long/short equity & directional strategies versus Equities • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … Long/Short Equity cluster Directional cluster Equitiy cluster • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG Comment: The chart shows the rolling average returns and standard deviations for two year periods between January 1990 and March 2004

  28. Non-traditional Traditional (Equities) Haus- farben Zusatz- farben • SCG • … • B 1 • … Non-traditional versus traditional • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG Comment: The chart shows the rolling average returns and standard deviations for two year periods between January 1990 and March 2004

  29. „Arbitrage“ cluster „Long/Short Equity“ cluster „Directional“ cluster Haus- farben Zusatz- farben • SCG • … • B 1 • … Hedge Fund Strategies Clusters • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Source: Swiss Capital Alternative Investments AG Comment: The chart shows the rolling average returns and standard deviations for two year periods between January 1990 and March 2004

  30. From clusters to fund of hedge fund portfolios ExpectedReturn Directional Fund of Fund Long/Short Equity Fund of Fund ArbitrageFund of Fund ExpectedRisk

  31. Haus- farben Zusatz- farben • SCG • … • B 1 • … Correlation between strategy groups and traditional asset classes • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Jan 1999 to June 2005

  32. Arbitrage Strategies* Long/Short Equity Strategies* Directional Strategies** Time period1996 - 2004 Volatility 3.55 9.74 10.92 -2.16 0.32 0.13 Skewness 9.26 1.64 0.27 *HFRI sub-indices**Barclay CTA index Haus- farben Zusatz- farben • SCG • … • B 1 • … Return distribution of hedge funds • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … Excess Kurtosis • B 6 • … • G 4 • … • S 1 • … • G 5 • … • The two main parameters in return distribution denotes risk and return characteristics : • Mean as expected return • Standard deviation as measure of risk • Normal distribution is when : • mean = median • skewness = 0 • No fat tails means kurtosis = 3 • S 2 • … • G 6 • … Return DistributionArbitrage Strategies • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  33. Haus- farben Zusatz- farben • SCG • … • B 1 • … While limiting drawdown risk, hedge funds have ‘fat tails’ • B 2 • … • R 2 • … Arbitrage Fund of Fund • B 3 • … • G 1 • … • Few drawdowns • But occasional ‘‘fat tail‘‘ events • „Fat tail“ events are laying the basis for new opportunities • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … Salomon Brother Investment Grade Bond Index (SBBIG) • S 2 • … • G 6 • … • S 3 • … • W • … • More drawdowns • Milder or almost no ‘‘fat tail‘‘ event • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  34. SCG • … • B 1 • … Fund of Hedge Funds constructions can mitigate unwanted characteristics • R 2 • … • B 2 • … • G 1 • … • B 3 • … • G 2 • … • B 4 • … • G 3 • … • B 5 • … • G 4 • … • B 6 • … • G 5 • … • S 1 • … • G 6 • … • S 2 • … • W • … • S 3 • … • G 1 • … • G 2 • … • G 3 • …

  35. Haus- farben Zusatz- farben • SCG • … • B 1 • … Wrap-up part 2 • B 2 • … • R 2 • … • Main factors influencing different strategies: - markets (stock, fixed-income, commodity) - risk premiums as indicator for risk aversion (volatility, credit spread) • Rationale of classifying Hedge Fund strategies in Arbitrage, Long/Short Equity and Directional is based on: - grouping strategies with similar quantitative characteristics (return, volatility, skewness, kurtosis) - providing the basis for the compilation of Fund of Hedge Fund portfolios with specific characteristics - supporting the integration process in a traditional portfolio • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • Topics in part 3 • Traditional assets – Hedge Fund concepts • Case Study • Some other issues to consider when investing in Hedge Funds • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  36. Haus- farben Zusatz- farben • SCG • … • B 1 • … Agenda • B 2 • … • R 2 • … • Part 1: Sources of Value in alternative strategiesPart 2: Overview of different hedge fund strategies Part 3: Integration of hedge fund of funds in traditional Portfolios • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  37. Haus- farben Zusatz- farben • SCG • … • B 1 • … Alternative strategies compared with traditional strategies Aktien • B 2 • … • R 2 • … Bonds Equity Equity/Commodity • B 3 • … • G 1 • … TraditionalAssets • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … Citigroup BIG Index (Start 93) MSCI World Index (Start 93) MSCI World Index (Start 93) • G 4 • … Arbitrage Convertible Arbitrage Fixed Income Arbitrage Equity Market Neutral Long/Short Equity Directional Global Macro Managed Futures • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … Alternative Assets • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Tremont Equity Market Neutral Index (Start 93) Tremont Long Short Equity Index (Start 93) Tremont Global Macro Index (Start 93)

  38. Haus- farben Zusatz- farben • SCG • … • B 1 • … Alternative assets in your portfolio Aktien • B 2 • … • R 2 • … Bonds Your portfolio Aktien Equity/Commodity • B 3 • … • G 1 • … TraditionalAssets • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … Citigroup BIG Index (Start 93) MSCI World Index (Start 93) MSCI World Index (Start 93) • G 4 • … Arbitrage Long/Short Equity Directional • S 1 • … • G 5 • … ExpectedReturn Directional Fund of Fund • S 2 • … • G 6 • … Long/Short Equity Fund of Fund • S 3 • … • W • … Alternative Assets • G 1 • … • Text • .. • .. ArbitrageFund of Fund • G 2 • … ExpectedRisk • G 3 • …

  39. Return μ Risk σ(Volatility, Skewness, Kurtosis) Sensitivity β Haus- farben Zusatz- farben • SCG • … • B 1 • … Objectives to be reached by investing in alternative strategies • B 2 • … • R 2 • … • Expected return: High probability of achieving superior return • Risk profile: Less drawdown than traditional investments • Sensitivity: Immunise or lower sensitivity to market risks of a traditional portfolio (fixed income, equity) • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  40. Haus- farben Zusatz- farben • SCG • … • B 1 • … Case Study: Swiss Pension Fund • B 2 • … • R 2 • … Pension Fund: • Major government pension fund • Assets of USD 9.7 bn • Main challenge: Fund‘s liabilities not fully covered; risk capability very limited with at the same time significant performance pressure • The fund has a „break-even“ return target of 3.50% - 4.00% (in CHF) • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … Investment objectives : • Fund of hedge fund portfolio with these parameters : • Return: 6% p.a. (in CHF) • Maximum volatility: 5% • Improve performance and limit drawdowns • B 6 • … • G 4 • … • S 1 • … • G 5 • … Limitation: • Maximum hedge fund allocation: 10% of total portfolio • S 2 • … • G 6 • … • S 3 • … • W • … Current portfolio: • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  41. Haus- farben Zusatz- farben • SCG • … • B 1 • … Integration Process (1): Current Situation • B 2 • … • R 2 • … Current situation: • B 3 • … • G 1 • … Focus: • Reduce drawdowns • Period 1: • Period 2: • Period 3: -2.81% -4.53% -4.21% • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … Core Objective: • Return • Volatility • Return: • Volatility: 4.99% p.a. 4.20% p.a. • S 1 • … • G 5 • … -0.0492 0.7761 -0.14 -0.2 Monitoring: • Correlation / Sensitivity • Skewness • Kurtosis • Correlation with Swiss Bonds: • Correlation with Swiss Equities: • Skewness: • Kurtosis: • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Results shown cover a period from January 1999 toJuly 2005

  42. Haus- farben Zusatz- farben • SCG • … • B 1 • … Integration Process (2): Composition of Fund of Hedge Fund Portfolio • B 2 • … • R 2 • … Allocationtraditionalasset classes Allocationnon-traditional products • Traditional portfolio: defensive positioning provides some drawdown protection already; problems: performance and risk of increased correlation between stocks and bonds • Rationale of allocation in Arbitrage Fund of Fund: backbone investment (steady return/low volatility), return enhancer with low beta to interest rates • Long/Short Equity Fund of Fund: return enhancer, increase in volatility justified, immunise against correction in stock markets • Rationale of allocation in Directional Fund of Fund: diversifier for traditional and non-traditional allocations, portfolio insurance in case of market dislocation • B 3 • … • G 1 • … • B 4 • … • G 2 • … Liquidity6% • B 5 • … • G 3 • … Bonds47% Arbitrage Fund of Fund35% + • B 6 • … • G 4 • … Real Estate24% • S 1 • … • G 5 • … • S 2 • … • G 6 • … Long/Short Equity Fund of Fund40% + Equities23% • S 3 • … • W • … Directional Fund of Fund25% + • G 1 • … • Text • .. • .. • G 2 • … Mixed Portfolio • G 3 • …

  43. Current situation: New mixed portfolio: HFoF portfolio: -2.81% -4.53% -4.21% -2.51% -3.45% -3.88% -1.39% -0.76% -1.74% 4.99% p.a. 4.20% p.a. 5.25% p.a. 3.88% p.a. 7.49% p.a. 3.90% p.a. -0.0492 0.7761 -0.14 -0.2 -0.0189 0.771 -0.1 -0.19 0.2877 0.1499 0.73 2.38 Haus- farben Zusatz- farben • SCG • … • B 1 • … Integration Process (3): Result after Integration (10% allocation) • B 2 • … • R 2 • … • B 3 • … • G 1 • … Focus: • Reduce drawdowns • Period 1: • Period 2: • Period 3: • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … Core Objective: • Return • Volatility • Return: • Volatility: • S 1 • … • G 5 • … Monitoring: • Correlation / Sensitivity • Skewness • Kurtosis • Correlation with Swiss Bonds: • Correlation with Swiss Equities: • Skewness: • Kurtosis: • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • … Results shown cover period from January 1999 to July 2005

  44. Haus- farben Zusatz- farben • SCG • … • B 1 • … Integration Process (4): Check-up (with 10% allocation) • B 2 • … • R 2 • … Focus: reduce/avoid drawdown Core objective: risk/return profile • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … Recovery comparison Achieving return targets • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  45. Haus- farben Zusatz- farben • SCG • … • B 1 • … Practical issue #1: Fund of Funds vs single HF investment • B 2 • … • R 2 • … • Single Hedge Funds can show fairly heterogeneous return pattern • Hedge Fund 3 follows a more defensive strategies with the other two positioned in a more aggressive segment • Hedge Fund #1 lost more than 30% in the last 12 months • Running a single Hedge Fund portfolio can pose high selection risks and requires know-how, expertise and serious infrastructure • For an allocation of 5 -10% in non-traditional assets, a diversified fund of hedge fund might be the most efficient option • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  46. Multi- Strategy FoF Single-Strategy FoF Strategy Multi- StrategyFoF 1 Multi- StrategyFoF 2 Arbitrage Fund of Fund Long/Short Equity Fund of Fund Directional Fund of Fund Arbitrage Strategy 20% 40% 100% Long/ Short Equity 20% 50% 100% Directional 60% 10% 100% Return p.a. 10.45% 9.93% Volatility 5.86 5.48% Sharpe 1.8 1.8 Beta to Stocks 0.24 0.15 Beta to Bonds -0.05 0.19 Haus- farben Zusatz- farben • SCG • … • B 1 • … Practical issue #2: Multi-Strategy FoF vs Single-Strategy FoF • B 2 • … • R 2 • … • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • Different Multi-Strategy FoF might look fairly comparable with regard to risk/return (Sharpe) • However, they can – given their different strategy allocation - show significant differences with regard to Betas; this aspect can be relevant for your portfolio • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  47. Haus- farben Zusatz- farben • SCG • … • B 1 • … Other practical issues • B 2 • … • R 2 • … • What does investing in alternative strategies mean for your investment team ? • The more integrated & involved, the more successful • What is the best investment strategy when you decide to add hedge funds in your portfolio ? • A core & satellite approach ? • Separate asset class or just a blend to traditional portfolio? • Most important is your investment objectives (what to be achieved with hedge funds), the rest are academic discussion • What is the most effective way to manage portfolio when I invest in several fund of hedge funds ? • Ask for transparency to understand your portfolio’s consolidated strategy mix and exposures • What is the best fund structure ? • Tailor-made investment structures (e.g. Dublin Qualified Investor Funds ) can reduce administrative burden and cost • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

  48. Haus- farben Zusatz- farben • SCG • … • B 1 • … Disclaimer • B 2 • … • R 2 • … Issued by Swiss Capital Alternative Investments AG (“SCAI"), regulated in Switzerland by Swiss Banking Commission. This presentation is for information purposes only and should not be construed as an offer to buy or sell any security, fund or other investment instrument or financial service. SCAI or any affiliate of SCAI Group or Swiss Capital Group may have a long or short position in any investment or related investment. Potential purchasers should determine for themselves the relevance of the information contained in this presentation and the decision to purchase any investment contained herein should be based on such investigation as they themselves deem necessary. These investments may not be offered or sold within the United States or to US persons. This presentation was prepared by SCAI exclusively for the benefit and internal use of potential institutional clients or purchasers in order to indicate, on a preliminary basis, the feasibility of a possible transaction or transactions. This presentation is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by SCAI. This presentation is proprietary to SCAI and may not be disclosed to any third party or used for any other purpose without the prior written consent of SCAI. Potential institutional clients or purchasers should consult with their own legal, regulatory, tax business, investment, financial, accounting or other advisors deemed necessary, and make their own decision based upon their own judgment and upon any advice from such advisors as is deemed necessary and not upon any view expressed by SCAI. This presentation is based on or derived from information generally available to the public from sources we believe to be reliable. No representation is made that it is accurate or complete. • B 3 • … • G 1 • … • B 4 • … • G 2 • … • B 5 • … • G 3 • … • B 6 • … • G 4 • … • S 1 • … • G 5 • … • S 2 • … • G 6 • … • S 3 • … • W • … • G 1 • … • Text • .. • .. • G 2 • … • G 3 • …

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