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Are Hedge Funds an Asset Class? Welcome to Today’s NACUBO Webcast Our program will begin shortly with a brief introduction on how to use the desktop interface. Desktop Interface Element Toolbar Media Player Element Display Quick Primary Question Toolbar CPE Credit You must complete surveys to receive CPE credit Resource Page Click directly in the element area to answer survey questions How to Ask Questions • Select “Expert” from the dropdown menu • Type your question • Click on Submit The Online Experts InBox button will illuminate when you receive a response. To view the answer to your question, click on this button and then select “Answered Questions.” Reviewing Elements • To review elements, use the Review and Preview buttons in the Element toolbar. • Click on the Sync button to rejoin the presenter. NOTE: This button appears “unplugged” if you are not synchronized with the presenter. Sync Review Preview Enlarge Buffering • If you experience sustained periods of buffering, click on the Speed button and select a lower stream rate. • Contact the helpdesk at 1-800-354-2665. Speed Button Hedge Fund Investing For Endowments NACUBO Web Cast Part Two Asset Allocation, Hedge Fund Portfolio Construction, Fixed Income Hedge Fund Strategies NACUBO Web Cast Part Two Joint Web Cast Sponsored by: NACUBO and Bear Stearns Moderator: Francie Heller, Bear Stearns Pension, Endowment, and Foundation Services Table of Contents 1. Review of Equity Hedge Fund Investing, Francie Heller 2. Integrating Hedge Funds Into the Asset Allocation Decision, Greg Dyra 3. Hedge Fund Portfolio Creation, Michael Norris 4. Fixed Income Hedge Fund Strategies, Heather Malloy i. High Yield, Leon Wagner ii. Relative Value Arbitrage, John Tsai iii. Emerging Markets, Fran Rodilosso 5. Fixed Income Historical Returns, Francie Heller 6. Summary of Asset Allocation, Greg Dyra 7. Questions 1. Review of Equity Hedge Fund Investing Francie Heller, Senior Managing Director Bear Stearns Pension, Endowment, and Foundation Services Overview of Hedge Funds • What is a Hedge Fund? – A private investment vehicle that seeks above average returns through active portfolio management – There is no statutory or regulatory definition of a Hedge Fund, although many have several characteristics in common Source: SEC, 17 CFR Parts 275 and 279, Release No. IA-2333; File No. S7-30-04, February 10, 2005. Overview of Hedge Funds • What is a Hedge Fund? – Characteristics in Common, cont. • Attempt to generate returns based on a unique skill or strategy the manager has that exploits an inefficiency in a particular area of the markets • Seek non-volatile absolute returns • Utilize short selling, leverage, derivatives, etc. • Organized by professional investment managers who frequently have a significant stake in the funds they manage • Funds have a management fee but compensation is heavily based on performance incentives Source: SEC, 17 CFR Parts 275 and 279, Release No. IA-2333; File No. S7-30-04, February 10, 2005. Equity Hedge Fund Strategies Covered in the Last Session • Long / Short Equity • Multi-Strategy • Equity Market Neutral • Convertible Arbitrage • Risk Arbitrage A Breakdown of Hedge Fund Strategies • Equity hedge fund strategies account for Q4 2006 ~50% of all Hedge Fund AUM Short Selling Convertible Arbitrage • Fixed Income and International strategies 0.29% 3.17% Sector (Total) 5.08% Distressed Securities 4.40% account for an additional ~40% of the Relative Value Arbitrage 13.23% Emerging Markets (Total) Hedge Fund Universe 4.39% Regulation D 0.24% • Sector specific, market timing and Merger Arbitrage 1.55% Market Timing 0.35% regulation D strategies make up the Equity Hedge remainder of AUM Macro 10.93% 28.67% FI: MBS 2.09% FI: High Yield 0.87% FI: Diversified 1.51% FI: Convertible Bonds 0.09% Equity Market Neutral FI: Arbitrage 2.53% Event-Driven 2.90% Equity Non-Hedge 13.55% 4.15% Source: HFR 2006-Q4 Industry Report Equity Hedge Fund Training Survey Results • In which strategy do you expect to make the greatest increase in your allocation? – Multi-strategy 52% – Long/short Equity 28% – Equity Market Neutral 10% – Convertible Arbitrage 7% – Risk Arbitrage 3% 2. Integrating Hedge Funds Into the Asset Allocation Decision Gregory J. Dyra Assistant Treasurer, Vanderbilt University (2004-January 2007) Portfolio Manager, Northwestern University (1996-99) Inv. Operations Manager, Northwestern University (1993-96) What Will We Cover Today? • Hedge fund allocations per NACUBO Endowment Studies • Institutional investment diversification approaches • If you want to be like Yale, you can study Yale – Art of contrarian thinking and patience for long term orientation – Science and limitations of mean variance optimization • Are hedge funds an asset class? – Return dispersion even within hedge fund strategies – Diversification approach can determine answer • Benchmarking choices for hedge funds as an asset class • Cautionary comments from hedge fund investors • Governance alignment, implementation and due diligence Large Endowment Asset Mix Changes Since 1988 1988 1991 1994 1997 2000 2004 2006 US Equity 45.6 45.9 40.2 39.4 32.4 24.6 28.8 Non-US Equity 3.1 6.0 13.5 14.8 13.5 16.5 16.2 Hedge Funds 0.7 2.0 6.4 8.8 11.7 24.4 22.4 Non-Marketable 3.8 5.3 6.2 7.1 18.7 13.3 14 Bonds 33.0 32.0 25.5 20.2 16.6 13.5 12.5 Real Estate 2.9 3.2 3.3 5.4 4.7 5.1 4.4 Cash 10.9 5.6 4.9 4.3 2.4 2.6 1.7 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: NACUBO Endowment Studies, © 2007 National Association of College and University Business Officers Large Endowment Diversification Produced Relatively Higher Nominal Returns Note: Dollar weighted figures are dominated by larger endowments. Source: 2006 NACUBO Endowment Study, © 2007 National Association of College and University Business Officers Endowment Universe Appears to Follow Large Endowments’ Affinity for Hedge Funds Source: 2006 NACUBO Endowment Study, © 2007 National Association of College and University Business Officers Average Hedge Fund Strategy as a Percentage of Total Hedge Funds Source: 2006 NACUBO Endowment Study, © 2007 National Association of College and University Business Officers Survey Question With the trend toward more hedge funds, do you see your institution’s objectives as: - Increase returns and therefore increase risks - Decrease risk through diversification -Both Institutional Investment Diversification Approaches Source: Greg Dyra Institutional Investment Diversification Approaches Source: Greg Dyra Survey Question What is the size of your endowment? -Mega (> $10 billion) -Large ($1-10 billion) -Mid-size ($0.5-1 billion) -Small (< $0.5 billion) Survey Question What do you feel represents the dominant diversification approach for your organization? -Keep it Simple -Style Diversifiers -Quants -Pioneers Yale’s Investment Process Balances Art & Science “Yale’s portfolio is structured using a combination of academic theory and informed market judgment. The theoretical framework relies on mean variance analysis... investment management involves as much art as science, qualitative considerations play an extremely important role in portfolio decisions. The definition of an asset class is quite subjective, requiring precise distinctions where none exist. Returns and correlations are difficult to forecast. Historical data provide a guide, but must be modified to recognize structural changes and compensate for anomalous periods.” Source: “The Yale Endowment Report: 2006” Art of contrarian thinking and long term orientation Investment Process - “Two important tenets of investment management - contrarian thinking and long-term orientation – create great difficulties for governance of endowment funds.” Investment Committee – “inspires staff to produce ever more carefully considered proposal…informed give and take brings dialogue to a higher level…oversees the investment process and supports the staff, while avoiding actual management of the portfolio.” Investment Staff –“drives the portfolio management process…intellectual dishonesty proves fatal to the investment process…comprehensive written treatments of investment issues…decision-making groups must be small, consisting of no more than 2 to 3 people… spreading power and delegating responsibility improve both performance and professional satisfaction.” Organizational Characteristics –“choose from a broader opportunity set…uncover highly motivated, attractive group of partners… focused mentorship provides essential training for new staff… frank, open discussion of previous failures and successes provides essential feedback for improved decision-making… collegiality plays a critical role.” SouSource: “Chapter 11. Investment Process” of “Pioneering Portfolio Management” by David F. Swensen The Science (and Art) of Absolute Return Mean Variance Optimization Assumptions Historical Capital Modified Expected Risk, Return Nature of Markets Data and Correlation Assumptions Modification Return 17.6% (nominal) 7.0% (real) lower Standard deviation 11.8% 15.0% higher Absolute return correlation to: U.S. equity .28 .30 higher U.S. bonds .15 .35 higher Developed equity .16 .30 higher Emerging equity .36 .30 lower Private equity .29 .25 lower Real estate .06 .40 higher Cash (.08) .00 higher Source: “Chapter 5. Asset Allocation” of “Pioneering Portfolio Management” by David F. Swensen Limitations of Mean Variance Optimization • Measuring the influence of significant, low-probability events, such as skewness or kurtosis, and forecasting the investors’ tolerance for skewness or kurtosis. – Example: Negative skewness is evident in the
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