Introduction to Hedge Funds Hedge funds –a separate asset class?
History, definition and characteristics of hedge funds
Risks, returns, correlations
Benchmarks and long term return outlook
Hedge funds in the context of a traditional investment portfolio
Conclusions
Introduction to Hedge Funds 2 Alternativeinvestments
Alternative Asset Class Forecasted Demand Growth
Hedge funds High
Private equity High
Commodities High
Credit (HY/ABS/MBS/CDOs) High
Real estate (resid., comm., infrastr.) High
Other (insurance, art, hybrids, etc) High
Introduction to Hedge Funds 3 Development of the hedge fund industry, 20% growth pa
1949: A.W. Jones launched the first hedge fund 1967: George Sorosstarted out 2004: Hedge fund industry reached USD 1,000 bn mark 2007: Industry at USD 1,700 bn, managed by 3,000-4,000 HF managers in 10,000-15,000 HFs $1,800,000 $1,745,214 $1,700,000 $1,604,600 $1,600,000 $1,464,526 $1,500,000 USD 1 bn mark $1,400,000 reached $1,300,000
$1,200,000 Institutional $1,105,385 $1,100,000 Investors enter
$1,000,000 $972,608
$900,000 LTCM $820,009 $800,000
$700,000 $625,554
A ss e t s ( I n $ M M) $600,000 $539,060 FedIR $490,580 $500,000 $456,430 hike $374,770 $400,000 $367,560
$300,000 $256,720 $185,750 $167,790 $167,360 $200,000 $99,436 $126,474 $95,720 $91,431 $73,585 $60,222 $58,370 $57,407 $55,340 $46,545 $70,635 $46,907 $58,663 $100,000 $38,910 $27,861 $36,918 $23,336 $8,463 $14,698 $4,406 $0 ($1,141) ($100,000) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Q1 Q2 2007 2007 Source: HFR Industry Report 2007 Q2 EstInimtroadtuecdt iAons tsoe Htsedge Funds Net Asset Flow 4 Hedge funds are a kind of progressive mutual funds
“OLD”definition of hedge funds
“All forms of investment funds, companies, and private partnerships that » use derivatives intensively for hedging or for directional investing » and/or engage in short-selling » and/or use significant leverage through borrowing.”
“NEW”definition of hedge funds
Active, absolute return oriented investment funds
Introduction to Hedge Funds 5 Hedge funds are more flexible than mutual funds
Specific hedge fund characteristics
Active management, take advantage of market inefficiencies
Focus on absolute performance and risk management
Great flexibility reg. asset classes, markets, trading styles, and instruments
Performance fee, own money invested
Infrequent liquidity and redemption dates
High minimum investment levels
Limited regulation and transparency, albeit improving
Introduction to Hedge Funds 6 It is important to distinguishbetween FoHFsandHFs
‘Hedge funds‘
Funds of hedge funds Hedge funds
HF1 HF2 HF3 HF n
Introduction to Hedge Funds 7 Commonly used legal structures
Fund of funds Hedge fund
Managed account Investment fund Structured product
Offshore limited co. Principal protected note US limited partnership Index certificate (fund-linked note) Swiss mutual fund Call option Swiss participation co. Total return swap SICAV CFO Unit trust Convertible Other Reinsurance-linked note
Introduction to Hedge Funds 8 Typical offshore structureof a fund offunds
Investor Sponsor
Investment Auditor Manager
Fund of Funds Ltd.
Investment Administrator Advisor
Custodian Hedge funds
Introduction to Hedge Funds 9 Typical offshore structureof ahedgefund
Investor
Investment Auditor Manager/Sponsor
HedgeFund Ltd.
Investment Administrator Advisor
Prime Broker Securities
ExecutionBrokers
Introduction to Hedge Funds 10 The roleofthedifferentcounterparties
HedgeFundLtd Offshore company with articlesofassociation, directors, andseveral share classes
Investor Holder ofthenon-voting,participating shares
Sponsor Holder ofthe voting, non-participating shares
Investment Manager Discretionary portfolio manager, typically offshore
Investment Advisor Non-discretionary ‘advisor’, typically onshore
Auditor Audits the balance sheet and P&L
Introduction to Hedge Funds 11 The rolesoftheprimebrokerandthe administrator
Primebroker Stocklendingandrepos Leverage Custodyofportfolio securitiesand cash Tradeexecutionandsettlement Backoffice facilities Officespace Legalassistance for setup Marketingsupport („capital introduction“)
Administrator Independent NAV calculation Handling of subscriptions and redemptions
Introduction to Hedge Funds 12 Master-feeder structures
US EU Offshore investors investors investors
HedgeFund HedgeFund HedgeFund LP (Cayman) Ltd. (Dublin) Ltd.
HedgeFund Portfolio Ltd.
Introduction to Hedge Funds 13 Cayman and theUS arethe most popular hedgefunddomiciles
Hedge Fund Domiciles
Other Sweden Channel Islands 7% 1% 3% Luxembourg 2% US Dublin 30% 4%
Bahamas 2%
Bermuda 8%
BVI 9% Cayman Islands 34%
Data: HFR,Harcourtestimates Introduction to Hedge Funds 14 2/3ofhedgefundmanagers are basedintheUS, but Europe and Asia are growing faster
Hedge Fund Management Company Locations
Asia 10% Greater NY 36%
Other Europe 8%
London Other US 18% 28%
Data: Harcourtestimates
Introduction to Hedge Funds 15 Roughly20%of allassets investedinhedge fundscomeout of Switzerland (directly & indirectly)
Hedge Fund Asset Origins
Other 25%
USA 50%
Japan 5%
Switzerland 20%
Data: Harcourtestimates Introduction to Hedge Funds 16 Hedge funds –a separate asset class?
History, definition and characteristics of hedge funds
Risks, returns, correlations
Benchmarks and long term return outlook
Hedge funds in the context of a traditional investment portfolio
Conclusions
Introduction to Hedge Funds 17 Harcourt strategyclassification framework
Fixed Income Equities Commodities
Relative Value Fixed Relative Value Equity Relative Value Commodity Income Strategies: Strategies: Strategies: 1. Multi-Strategy Fixed Income 9. Multi-Strategy Equity 22. Multi-Strategy Commodity Relative 2. Fixed Income Arbitrage 10. Event Driven Equity 23. Relative Value Energy Value 3. ABS & MBS 11. Convertible & Volatility Arbitrage 4. Asset-Based Lending 12. Structured Equity Linked 13. Statistical Arbitrage 14. Market Neutral Equity
Directional Fixed Income Directional Equity Strategies: Directional Commodity Strategies: 15. Long/Short Global Equity Strategies: 5. Long/Short Rates 16. Long/Short US Equity 24. Metals Trading 6. Long/Short Credit 17. Long/Short European Equity 25. Agricultural Trading 7. Distressed Securities 18. Long/Short Japanese Equity 26. Energy Trading Directional 8. Emerging Markets Debt 19. Long/Short EM Equity 27. Power & Emissions Trading 20. Long/Short Sectors 21.Short-Biased Equity
Directional Multi-Asset Class Strategies: 28.LT Trend-Following CTAs 29.ST Systematic Trading CTAs 30. Global Macro 31. Insurance-Linked
Introduction to Hedge Funds 18 Long/short equity is the most popular hedge fund strategy
Hedge fund strategies (by # of funds) Hedge fund strategies (by AUM)
CTAs & Macro 14% CTAs & Macro Directional 22% Fixed Income Long/Short 6% Equity 39% Relative Value Long/Short Fixed Income Equity 6% 48% Directional Fixed Income 8% Relative Value Equity 26% Relative Value Relative Value Fixed Income Equity 5% 26%
Data: HFR, Harcourtestimates Introduction to Hedge Funds 19 Mostimportant hedgefundrisks
Marketrisks: Stockmarket beta,interestrateduration,credit spreads, FX movements
Strategy risks: Supply/demandineach strategy eg inefficiencies,spreads, capacity;trends/market patterns; specificstrategy risks eg mergerdealbreaks,mortgage prepayments,realized and impliedvolatilities
Leverage: Amplificationeffect,funding/margincall risk
Liquidity risks: Bid-askspread risk,investor redemptionrisk
Valuation risks: Mark-to-market risk, independent valuations
Companyrisks: Growthof AUM, style drift, ‘keypeople‘risk, backoffice risk, legal risk
Introduction to Hedge Funds 20 Leverage: many hedge fund strategies are not or only moderately leveraged
No leverage (0 -1.0 : 1) Some long/short equity funds Distressed securities Short-biased equity
Low leverage (1.1 -2.0 : 1) Most long/short equity funds Most long/short credit funds Merger arbitrage
Moderate leverage (2.0 -7.0 : 1) Convertible arbitrage Statistical arbitrage CTAs Mortgage-backed securities arbitrage
High leverage (8.0 -20.0 : 1) Fixed income arbitrage
Introduction to Hedge Funds 21 Leverage vs. market exposure: are hedge funds riskier than traditional mutual funds?
Swiss Stocks Mutual Fund: 95% long stocks, 5% cash => net long exposure of 95% => leverage of 0.95:1
Long/Short US Equity Hedge Fund: 85% long stocks, 45% short stocks => net long exposure of 40% => leverage of 1.3:1
US Convertible Arbitrage Fund: 300% long convertibles, short delta stocks, short interest rates, short credit => net long exposure of 0% => leverage of 6.0:1
Fixed Income Arbitrage Fund: 800% long bonds, 800% short bonds => net long exposure of 0% => leverage of 16.0:1
CTA: 20% margin in long and short futures positions => long exposure 200%, short exposure 200% => leverage of 4.0:1
=> Conclusion: leverage should always be considered in connection with actual market risk exposure, as well as basis risk and other risks
Introduction to Hedge Funds 22 Hedge funds have performed similar to stocks and bonds over the last ten years
16%
Sector 14% L/S Equity
Distressed 12% Hedge Fund Index EM Merger Arb 10% Macro CV Arb MBS
8% MN Equity Fund of Funds FI HY MSCI World
R e t u r n pa JPM 6% FI Arb CTAs
4%
2% Short
0% 0% 5% 10% 15% 20% 25% Standard deviation pa
Data: HFRHF, Barclay CTAIndices 1994 -Aug 2007 Introduction to Hedge Funds 23 All hedge fund strategies have outperformed stocks since January 2000
250
200
150
100
50 J u n - 00 J u n - 01 J u n - 02 J u n - 03 J u n - 04 J u n - 05 J u n - 06 J u n - 07 M a r- 00 M a r- 01 M a r- 02 M a r- 03 M a r- 04 M a r- 05 M a r- 06 M a r- 07 D e c - 99 S e p - 00 D e c - 00 S e p - 01 D e c - 01 S e p - 02 D e c - 02 S e p - 03 D e c - 03 S e p - 04 D e c - 04 S e p - 05 D e c - 05 S e p - 06 D e c - 06 S e p - 07 MSCI World $ HFR HF Index CV arb Distressed Eq hedge FI arb MBS Merger arb Sector Short-selling CTAs Funds of funds
Data:HFR, Barclay Introduction to Hedge Funds 24 Each strategyhas a differentrisk/return profile
2007 July YTD Ret pa Ret pa Stdev pa Corr MSCI Est. 1994-2007 2000-2007 2000-2007 2000-2007 HFRI FoF Index (non-investable, net) 8.19% 7.74% 6.49% 4.41% 0.57 HFRI Global HF Index (non-investable, gross) 7.61% 11.57% 8.38% 5.87% 0.76 CSFB/Tremont HFs (investable, gross) 5.47% n/a 7.51% 2.98% 0.27 FTSEhx (investable, net) 4.46% n/a 5.77% 3.39% 0.32 Long/short equity 8.31% 14.04% 7.82% 7.77% 0.73 Sector specialists 7.31% 13.98% 6.36% 13.35% 0.66 Event driven 7.33% 13.29% 10.62% 5.73% 0.71 Distressed securities 6.23% 12.20% 12.61% 4.53% 0.50 Emerging markets 18.08% 12.05% 15.09% 10.39% 0.74 Merger arbitrage 5.59% 10.17% 7.65% 3.37% 0.46 Macro 6.55% 9.89% 8.02% 5.49% 0.29 Relative value arbitrage 5.67% 9.78% 8.74% 2.18% 0.40 MBS arbitrage 2.50% 9.30% 8.48% 3.62% 0.10 Convertible arbitrage 4.16% 9.15% 7.97% 3.27% 0.09 Market neutral equity 4.83% 7.89% 6.08% 2.72% -0.02 Statistical arbitrage 7.04% 7.71% 5.15% 3.68% 0.59 High yield 1.49% 7.20% 6.87% 3.69% 0.46 Fixed income arbitrage 1.81% 5.88% 6.28% 2.37% 0.05 CTAs 1.80% 5.48% 5.10% 7.41% -0.13 Short-selling 0.88% 0.79% 5.54% 20.39% -0.71 MSCI World 5.54% 7.27% 1.29% 13.50% 1.00 JPM Global Bonds 1.58% 6.90% 5.71% 2.89% -0.31
Data:FTSE, HFR, Barclay Introduction to Hedge Funds 25 Hedgefundspreservecapitalin badtimes
40% 33.2%
30% 23.8% 20.5% 20% 16.5% 17.0% 17.4% 14.2% 10.2% 8.4% 10% 7.1% 6.1% 5.6% 6.5% 3.5% 4.0% 0.7% 0.4% 0%
-2.7% -10% Light colors: 1/1994-3/2000 Dark colours: 4/2000-3/2003 -20% -17.3% -17.2% -19.4%
-30%
-33.6% -40% HFR Fund of HFR CSFB/Tremont CTAs HFR MSCI World S&P 500 NASDAQ SPI (CHF) JP Morgan Pictet (CHF) Funds Index Composite HF Index Long/Short (USD) Composite Global Bond Index Equity Index Index (USD)
Data:HFR, Barclay Introduction to Hedge Funds 26 Low cross-correlations permit efficient portfolio diversification
Data: HFRHF, Barclay CTAIndices 1994 -Aug 2007 Introduction to Hedge Funds 27 Diversification lowers risk
Theoptimalnumberoffunds seems to bebetween15and 30 However, depending on the investor‘s specific utility curve (eg single HF fall out risk) the number may be significantly higher
25% Single manager managed futures 100 largest U.S. stocks Single manager hedge funds 20%
15%
10% S t a n d r e v i o p . a. 5%
0% 0 5 10 15 20 25 30 Number of funds/programs/stocks
Note: Attrition rate of HFs is similar to attrition rate of mutual funds Data: TASS, HFR, MSCI Introduction to Hedge Funds 28 The selection of the right hedge fund strategy is crucial to achieve a low correlation to stock and bondportfolios
Correlation betweenFoHFcompositeandMSCI World, JPMGlobal Bonds
1.00 0.80 0.60 0.40 0.20 0.00 -0.20 -0.40
-0.60 12-month rolling correlation to global stocks -0.80 12-month rolling correlation to global bonds -1.00 M - 90 M - 91 M - 92 M - 93 M - 94 M - 95 M - 96 M - 97 M - 98 M - 99 M - 00 M - 01 M - 02 M - 03 M - 04 M - 05 M - 06 M - 07
The high correlation to the MSCI World is mostly driven by the large amount of long-biased long/short equity hedge funds (appr. 40%). Other strategies are less correlated.
Data: HFRI
Introduction to Hedge Funds 29 Hedge funds –a separate asset class?
History, definition and characteristics of hedge funds
Risks, returns, correlations
Benchmarks and long term return outlook
Hedge funds in the context of a traditional investment portfolio
Conclusions
Introduction to Hedge Funds 30 Investable hedge fund indices
CSFB Tremont www.hedgeindex.com Asset-weighted; 10 strategies; invested in 60 HFs
Dow Jones www.djindexes.com Equal weighted; 1 directional, 5 non-directional strategies; invested in 32 HFs
FTSE Hedge www.ftse.com Triple investibility weighted; 8 strategies; invested in 40 HFs
HFRX www.hedgefundresearch.com Equal weighted; 8 strategies; invested in 80 HFs
MSCI www.msci.com/hti Complex weighting; 8 strategies; invested in 138 HFs
Introduction to Hedge Funds 31 Non-investable hedgefundindices
Barclay Trading www.barclaygrp.com Equal-weighted CTA-Index; 17 strategies Group (2,080 CTAs)
CSFB/Tremont www.hedgeindex.com Asset-weighted HF Index and 13 HF sub-indices (434 HFs)
Eureka Hedge www.eurekahedge.com Several industry indices
HedgeFund www.hedgefundresearch.com Equal-weighted HFRI Index and 32 HF Research sub indices (1,700 HFs)
InvestHedge www.hedgefundintelligence.com Several industry indices
MSCI www.msbarra.com Equal-weighted and asset-weighted indices; 18 strategies (2,800 HFs)
Introduction to Hedge Funds 32 Funds of funds have underperformed the HF index
16%
Sector 14% L/S Equity
Distressed 12% Hedge Fund Index EM
Merger Arb 10% Macro CV Arb MBS
8% MN Equity FI HY Fund of Funds MSCI
R e t u r n pa JPM World 6% FI Arb CTAs
4%
2% Short
0% 0% 5% 10% 15% 20% 25% Standard deviation pa Data: HFRHF, Barclay CTAIndices 1994 -Aug 2007 Introduction to Hedge Funds 33 Possible explanations for the perceived underperformance of fundsoffunds
•Fund of fund fees (average management fee of 1.25% and average performance fee of 12.5%)
•Survivorship and selection bias disregarded in hedge fund indices (estimates range from 1.0% to 4.0% pa)
•Bull market bias of hedge fund indices (40-50% of hedge funds do long/short equity)
•Poor selection, low barriers to market entry
Introduction to Hedge Funds 34 Hedge funds are hedged and provide an asymmetric return profile
10000
Hedge Fund Composite Index
JPM Global Bond Index
MSCI World Index
1000
100 J un - 86 J un - 87 J un - 88 J un - 89 J un - 90 J un - 91 J un - 92 J un - 93 J un - 94 J un - 95 J un - 96 J un - 97 J un - 98 J un - 99 J un - 00 J un - 01 J un - 02 J un - 03 J un - 04 J un - 05 J un - 06 J un - 07 D e c - 85 D e c - 86 D e c - 87 D e c - 88 D e c - 89 D e c - 90 D e c - 91 D e c - 92 D e c - 93 D e c - 94 D e c - 95 D e c - 96 D e c - 97 D e c - 98 D e c - 99 D e c - 00 D e c - 01 D e c - 02 D e c - 03 D e c - 04 D e c - 05 D e c - 06 Data: Harcourt, TASS, HFR, Barclay Introduction to Hedge Funds 35 Longterm hedgefundreturn outlook
Hedge fund returns are a function of: l Stock market returns l Libor and bond rates l Market liquidity l Strategy alpha, iemarket inefficiencies and supply/demand imbalances
Expected long term returns: Libor + 500 pa
Introduction to Hedge Funds 36 Hedge funds –a separate asset class?
History, definition and characteristics of hedge funds
Risks, returns, correlations
Benchmarks and long term return outlook
Hedge funds in the context of a traditional investment portfolio
Conclusions
Introduction to Hedge Funds 37 Hedge funds are the perfect diversification tool for a traditional stock/bond portfolio
Addition of hedge funds to a 50% stock and 50% bond portfolio results in lower risk/higher return portfolio 10%
HFRI FoF Index MSCI World $
JPM Global Bonds $
5% R e t u r n pa
0% 0% 4% 8% 12% Standard deviation pa
Data: 1994-Aug 2007 Introduction to Hedge Funds 38 Aggressive or conservative? Trade-off of equity correlation vs returns
Fund of funds performance
20%
18%
16% Aggressive FoF
14% “Equity surrogate“
12%
10%
8% N e t r u n pa
6%
4% Conservative FoF “Bond surrogate“ 2%
0% -0.20 0.00 0.20 0.40 0.60 0.80 1.00 Correlation to S&P 500
Data: Altvest, S&P, Jan-94 to Dec-99 Introduction to Hedge Funds 39 There are two typesofhedgefundinvestors
Two types of investors
Type A: Type B: HFs as a separate HFs as an active overlay asset class to a passive portfolio
• Diversification • Passive Index + HFs = Active
Introduction to Hedge Funds 40 Type A –Driven by „Core-Satellite“investment approach
Core portfolio:PASSIVE Satellite portfolio:ACTIVE
Majordevelopedstock andbond HFs, small caps, EM, high yield, PE, markets(large caps) ABS, real estate
Indices, ETFs,tracker funds, Active long-only mandates/funds, passivemandates portable alpha/overlay, hedge funds
Introduction to Hedge Funds 41 Type B – Driven by paradigm shift in the asset management industry
Past Present Future
8% 10% Passive beta strategies 35%
90% 85% Active long only (beta) strategies 50%
Active 2% 5% alpha 15%
Beta will increasingly be bought cheaply through passive instruments (ETFs, indices)
The importance of Alpha as a portfolio component will likewise increase
Data: Man Investments Introduction to Hedge Funds 42 Hedge fund returns –Alpha oderbeta?
Hedge fund returns = Traditional betas + alternative betas + structural alpha+ skill alpha
Traditional beta = Alternative beta = Structural alpha = free Skill alpha = only few directional risk premia: Directional and option due to structural really skilled demand/supply premia: advantages: managers:
-Stock market beta -Liquidity risks -Regulatory constraints -Analysis -Interest rate duration -Spread risks -Structural inefficiencies -Portfolio mgt -BARRA factors -Volatility and correlations -Informational barriers -Risk mgt -Credit spreads -Merger deal risk -Speed and size etc. -Currencies -Prepayment risk -Trend-following etc. etc. etc.
Passive Active
The source of returns varies significantly across the different HF styles, HF strategies and HFs…and varies over time !
Copyright: Harcourt Research Introduction to Hedge Funds 43 The asset management industry of the future
Þ Hedge funds will become mainstream
Þ Traditional and alternative asset management industries will merge
Þ Seggregation of the traditional value chain:
BETA exposure via low-fee index certificates,
ALPHA (and Alternative Beta) via high-fee hedge fund-like investment vehicles
Introduction to Hedge Funds 44 Hedge funds –a separate asset class?
History, definition and characteristics of hedge funds
Risks, returns, correlations
Benchmarks and long term return outlook
Hedge funds in the context of a traditional investment portfolio
Conclusions
Introduction to Hedge Funds 45 Whyhedgefunds?
Superior risk-adjustedreturnsin bearand bullmarkets
Lowto moderate correlationto traditional asset classes
Asymmetricreturndistribution–downsideprotection
Access to someof thebest talentin financialmarkets
Highlysophisticated, unbiasedinvesting
Transparency and regulation improving on the back of increasing institutionalisation
=> Hedge funds belong in every diversified investment portfolio
=> Demand for hedge funds will remain high, and hedge funds will become mainstream
Introduction to Hedge Funds 46 Disclaimer
An investment in an alternative investment carries substantial risks. The nature and extent of some of these risks differ from traditional investments in stocks and bonds. There can be no assurance that the advice or information provided above will lead to superior performance. In particular, the performance of an alternative investment may vary substantially over time. Investors bear the risk of losing all or part of their investment and thus should carefully consider the appropriateness of such investments for their portfolio. While the information contained in this document has been obtained from sources deemed reliable, no representation is made as to its accuracy or completeness, and it should not be relied on as such. Past performance is not necessarily indicative of future performance.
Introduction to Hedge Funds 47 Contact
Harcourt Investment Consulting AG Stampfenbachstrasse 48 8006 Zürich -Switzerland
Contact us: Tel: +41 (0)44 365 1000 Fax: +41 (0)44 365 1001 To access Harcourt research and educational material please visit: www.harcourt.ch
Introduction to Hedge Funds 48