Asset Allocation and the Use of Hedge Funds

1. Asset Allocation and the Use of Hedge Funds CFA Traveling Conferences June 2008

2. Asset Allocation and the Use of Hedge Funds • Growth of the hedge fund industry and ramifications for return expectations • Risk measurement and management of hedge funds • Where hedge funds fit in a long-term portfolio strategy for high-net-worth investors

3. Hedge Funds Today? • Hedge funds are risky and speculative investments that do not perform • Increase in the numbers hedge funds will lead to erosion of returns • The higher the Sharpe and the lowest the correlation, the better an alternative investment is

4. 1. Capacity and Performance: Only Alpha? • The reality of hedge fund returns: alpha and beta, inefficiencies and timing • Does a simple regression capture properly an asset manager’s return? • Isn’t alpha scarce and unstable? • Future growth and capacity in the long run

5. Beta Is Increasing and Alpha Decreasing

6. Beta Exposure Movements in Different Market Environments Did not participate in the bear market Participates in the bull market Defensive mood looking forward. Therefore, less up participation today Recently Beta is decreasing Participation in the up market

7. Sources of Hedge Fund Performance RHedge Funds =  + Traditional + Alternatives • Market inefficiencies-Beta Allocation Skill& Selection Skill • Traditional Risk premium: Equity Risk Duration Risk • Alternative Riskpremium: Small Cap vs. Large Cap Implied Volatility (VIX) Credit Spread Systematic Behaviour It is not because a manager is exposed to traditional  or alternative  that he will perform, the manager’s skill matters

8. Infinity of Sources of Return • Alpha is a small part of the returns (20%) • Betas are liquid and readily available • Skills matter • A regression, a number, doesn’t capture behavior • The beta discussion is hence a rhetorical one

9. Hedge Funds Are Mutants • Example of recently developed non-scalable niches: • Structured finance • PIPE (private investment in public equities) • CDO / CDS / abs / ABL • Latin America • Indian long short • Example of recently developed scalable niches: • Shareholder activism • Quant strategies • Natural resources / themes • Distressed

10. 3. Fitting hedge funds to private client portfolios • Dual Benchmarks investors: • Cash Minimum or • Whatever goes up the most (especially if my friends have it) • Hedge Funds will never compete with high performing long only assets • Hedge Funds can help true diversification

11. Good use of HF Allocation • Risk taking in alternative betas • Bond Substitution • Equity Substitution for conservative mandates • Profitable and Sticky for bank (not!)

12. Target NAV after 3 years 128 The Risk is one of NOT reaching a target in a time period

13. Target Fund of Hedge Funds Global Bonds Can you afford this? - 47.9% Drawdown 31 Months Global Equities In the Long Run Hedge Funds Outperform

14. Who Cares About the Long Run • Dual Benchmark requires • Dynamic Risk Taking in Long Only Asset Classes • Further Risk Taking with Aggressive Alternative Beta providers (Credit, Distressed, Macro, High Vol Market Neutral) • Risk Diversification (Vol Arb, Convertible Arbitrage, Stat Arb, Long Short Equity, Long Only Absolute Return)

15. Q&A

16. Appendix

17. +Alternatives Identification of Alpha & Beta components by EIMHedge Fund performance is a function of Alpha and Beta Sourcesof Hedge Fund Performance RHedge Funds =  + Traditional

18. Identification of Alpha & Beta components by EIMBeta: The Framework Market Risk Exposure + Systematic Behaviour = Beta Can be either classified as Traditional orAlternative

19. Identification of Alpha & Beta components by EIMBeta: The Framework Market Risk Exposure + Systematic Behaviour Traditional: Buy & Hold Traditional: Long Only positions Ex: Long Equity Long AAA Bonds Alternative: Exposure to market involving Short Selling and/or Leverage. Ex: Long Value / Short Growth Credit Spread Alternative: Variable OptionalityLong OptionalityShort Optionality

20. Traditional Market Exposure + Traditional Behaviour Identification of Alpha & Beta components by EIMExamples of Traditional and Alternative Betas Investment Methodologies Equity / Buy & Hold Traditional Market Exposure + Traditional Behaviour Equity / Variable, Longor Short Optionality Traditional Market Exposure +Alternative Behaviour Equity Small vs Large / Buy & Hold Alternative Market Exposure+ Traditional Behaviour Long Short Equity / Variable, Long or Short Optionality Alternative Market Exposure+Alternative Behaviour Private Equity / Buy & Hold

21. Identification of Alpha & Beta components by EIMExamples of Traditional and Alternative Betas Investment Methodologies Equity / Buy & Hold Traditional Beta Equity / Variable, Longor Short Optionality Alternative Beta Equity Small vs Large / Buy & Hold Alternative Beta Long Short Equity / Variable, Long or Short Optionality Alternative Beta Private Equity / Buy & Hold Traditional Beta

22. Identification of Alpha & Beta components by EIMThe complexity and combination of different Betas is large • Equity β, Fixed Income Duration, Credit Duration times Systematic Behaviour Buy & Hold= 3 Traditional Beta’s

23. Minimum 18 Alternative Risk Factors times 4 Systematic Risk Control Behaviours= 72 Alternative Beta’s