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

Note: Dollar weighted figures are dominated by larger endowments.

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 monthly return histograms for many hedge fund indices. Also investors clearly have a preference for the extreme positive skewness of the venture capital distribution of Google and an aversion for the negative skewness of the bursting of the internet bubble. Duke’s Professor Campbell R. Harvey has studied and written extensively on the use of these higher moments of risk in mean variance optimization. • Measuring the degree of illiquidity for each asset class and forecasting investor’s liquidity requirements. – Example: Hedge funds often can invest in illiquid positions which may not match up with investor lockups. Associate professor, Rui de Figueiredo, PhD of the Haas School of Business at the University of California at Berkeley, has published results that depart from conventional wisdom with regard to illiquid asset classes such as buyouts and venture capital. • Integrating conditional economic forecasting of inputs into mean variance optimization. – Example: Equity returns, risks and correlations are highly sensitive to the business cycle and the slope and inversion of the yield curve (or term structure) has demonstrated the ability to predict economic recessions. Duke’s Professor Campbell Harvey has studied and written extensively on conditional weighting in asset allocation. Are Hedge Funds an Asset Class? Return Dispersion Indicates Manager Heterogeneity

Quartile Ranking Bar – Equity Long / Short Universe (12/31/95-12/31/06) 175

150

125

100 75

25 RATE OF RETURN 0 -25

-50

12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 HIGH (0.05) 27.46 33.49 28.22 52.33 23.36 32.40 51.40 143.67 57.56 58.21 66.61 FIRST QUARTILE 13.94 15.48 12.86 24.98 7.33 14.59 27.99 50.98 24.83 34.85 28.32 MEDIAN 8.90 10.08 7.79 15.29 0.57 7.31 16.95 33.68 10.80 23.51 21.42 THIRD QUARTILE 4.70 6.13 3.90 8.51 -7.51 0.21 9.15 21.94 4.01 14.18 15.57 LOW (0.95) -10.65 -4.75 -4.27 -3.10 -23.38 -16.88 -19.83 -6.94 -20.42 -0.24 -2.42 MEAN 9.12 11.22 8.66 17.31 0.66 7.93 17.16 38.11 13.96 23.95 23.67 VALID COUNT 509 439 339 276 223 169 126 90 73 58 43 12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK CSFB HEDG Long/Short Equity 14.38 22 9.68 53 11.57 29 17.30 44 -1.60 60 -3.67 85 2.08 84 47.22 33 17.19 38 21.46 53 17.14 67

Source: PSN Enterprise software with The Barclay Group Hedge Fund Universe Data Are Hedge Funds an Asset Class? Return Dispersion Indicates Manager Heterogeneity

Quartile Ranking Bar – Macro Universe (12/31/95-12/31/06) 150

125

100 75

25 0 RATERETURN OF -25

-50

-75

12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 HIGH (0.05) 26.02 33.34 19.63 69.72 43.52 41.12 59.65 105.95 32.72 33.55 59.46 FIRST QUARTILE 13.40 16.50 11.25 35.75 15.91 17.35 21.48 27.48 15.76 26.08 57.42 MEDIAN 5.91 8.91 8.03 24.34 7.31 8.40 8.14 10.33 5.55 18.92 9.91 THIRD QUARTILE 0.77 4.47 5.21 12.91 1.27 1.68 -3.59 5.02 3.96 13.92 3.71 LOW (0.95) -7.96 -6.17 -6.97 2.16 -14.86 -13.86 -13.63 -6.80 -45.10 6.24 2.38 MEAN 7.23 10.52 7.69 26.26 9.09 10.00 10.01 24.17 6.62 19.33 21.39 VALID COUNT9785725745373327191611 12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK CSFB HEDG Global Macro 13.54 22 9.25 48 8.49 41 17.97 63 14.67 31 18.38 21 11.69 39 5.81 70 -3.63 84 37.11 1 25.60 27

Source: PSN Enterprise software with The Barclay Group Hedge Fund Universe Data Are Hedge Funds an Asset Class? Return Dispersion Indicates Manager Heterogeneity

Quartile Ranking Bar – Event Driven Universe (12/31/95-12/31/06) 125

100

RATE OF RETURN -25

-50

-75

12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 HIGH (0.05) 43.28 26.42 49.15 54.45 20.83 54.88 75.88 64.83 16.75 41.16 54.21 FIRST QUARTILE 18.72 12.19 19.12 30.42 8.25 14.94 20.12 31.14 7.57 28.02 25.34 MEDIAN 13.83 7.26 13.56 18.87 3.9 0 7.41 10.64 18.15 4.67 22.12 18.94 THIRD QUARTILE 10.76 4.43 9.00 12.99 -2.28 2.31 2.42 13.67 -13.01 16.48 16.00 LOW (0.95) 3.40 0.14 3.27 4.75 -18.41 -2.45 -11.38 2.84 -25.69 12.61 10.48 MEAN 14.89 8.91 15.42 22.93 2.41 10.74 11.20 22.68 0.15 23.75 21.28 VALID COUNT 101 87 73 63 46 43 36 33 26 23 18 12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK CSFB HEDG Event Driven 15.75 36 8.94 41 14.45 46 20.02 42 0.16 60 11.49 37 7.24 63 22.26 30 -4.87 73 19.97 65 23.04 27 CSFB HEDG Event Driven Multi-Strategy 16.41 34 7.21 51 14.03 49 17.20 55 1.23 58 6.81 51 11.83 47 23.01 30 -8.97 73 20.53 56 22.71 27

Source: PSN Enterprise software with The Barclay Group Hedge Fund Universe Data Are Hedge Funds an Asset Class? Return Dispersion Indicates Manager Heterogeneity

Quartile Ranking Bar – Relative Value Arbitrage Universe (12/31/95-12/31/06) 70

10 RATE OF RETURN RATE OF 0 -10

-20

12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 HIGH (0.05) 30.60 22.14 22.94 48.91 21.69 27.78 50.07 50.13 18.99 25.83 32.07 FIRST QUARTILE 18.12 10.52 11.91 16.37 11.08 14.42 30.44 25.89 12.86 20.67 25.26 MEDIAN 13.85 5.42 6.10 10.92 7.54 11.10 19.87 15.62 4.70 17.56 17.51 THIRD QUARTILE 9.10 3.30 3.70 8.09 3.49 6.98 14.48 13.79 2.70 11.71 12.36 LOW (0.95) -1.04 -6.42 0.40 1.53 -6.14 -5.42 1.37 6.89 -8.19 9.08 7.91 MEAN 13.58 6.83 7.98 14.22 7.24 10.61 21.99 20.14 5.80 16.80 18.45 VALID COUNT 115 98 81 72 55 47 37 29 26 18 16 12/2005- 12/2004- 12/2003- 12/2002- 12/2001- 12/2000- 12/1999- 12/1998- 12/1997- 12/1996- 12/1995- 12/2006 12/2005 12/2004 12/2003 12/2002 12/2001 12/2000 12/1999 12/1998 12/1997 12/1996 VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK VALUE RANK CSFB HEDG Convertible Arbitrage 14.30 44 -2.55 96 1.98 87 12.88 36 4.04 72 14.58 23 25.65 32 16.03 48 -4.42 88 14.48 66 17.87 43 CSFB HEDG Equity Market Neutral 11.15 68 6.14 41 6.50 48 7.06 7 9 7.44 50 9.30 55 14.98 72 15.32 62 13.32 19 14.82 66 16.60 56 CSFB HEDG Fixed Income Arbitrage 8.65 76 0.63 91 6.85 45 7.96 75 5.73 61 8.03 68 6.29 97 12.10 75 -8.16 96 9.35 94 15.93 56

Source: PSN Enterprise software with The Barclay Group Hedge Fund Universe Data Are Hedge Funds an Asset Class?

No Yes Maybe

Asset allocation fit Tactical additions to stock Strategic asset class Strategic asset class and bond asset classes Explanation Separate beta and alpha Broadly diversified set of “Absolute Return” subset; because strategies are hedge fund strategies may also be described as heterogeneous “low correlation strategies” Example Long short equity manager is Broad set of hedge fund Yale’s event driven and value integrated into the long only strategies are combined to driven strategies stand alone equity portfolio construct a hedge fund as a separate asset class allocation Effect of example Variable exposures of hedge Generates equity-like returns Adds significant diversification fund can distort beta, style, and single-digit volatility while and generates high long term sector, geography, etc. relative providing moderate real returns by exploiting to the long only benchmark diversification market inefficiencies Potential use of Rebalance the long only Rebalance the hedge fund Rebalance the absolute return ETF’s, futures, swaps portfolio exposures to portfolio exposures to portfolio exposures to or other derivatives target systematic exposures avoid systematic exposures avoid systematic exposures Benchmark Choices For Hedge Fund Asset Class

Active Benchmarks (manager selection effect): – Credit Suisse/Tremont Hedge Fund Index – Credit Suisse/Tremont Multi-Strategy Index – HFRI Fund Weighted Composite Index – HFRI Fund of Funds Composite Index

Passive Benchmarks (asset allocation effect): – 90-day Treasury Bills + 5% – London Interbank Borrowing Rate (LIBOR) + 5% – 1-year Constant Maturity Treasury + 6% – (70% x Treasury Bills) + (30% x Russell 3000) + 2.5% Survey Question

In your opinion, are hedge funds an asset class?

–No –Yes –Maybe Cautionary Comments from Hedge Fund Investors

Æ Half are concerned with in-house risk management tools/ analysis Æ One quarter of investors’ governing body lacks understanding.

Source: State Street Corp.’s 2007 Hedge Fund Research Study of attendees of October 2006 Global Absolute Return Conference Cautionary Comments from Hedge Fund Investors

Most Cited Challenges of Hedge Fund Investing

• Returns and finding “alpha” • Acceptable fees • Risk measurement and analysis • Transparency and disclosure • Maintaining comfort level • Finding “good” managers to invest with when increasing hedge fund allocation

Source: State Street Corp.’s 2007 Hedge Fund Research Study of attendees of October 2006 Global Absolute Return Conference Secular Decline in Hedge Fund Returns Rolling 24-month Returns from 1994-2006

Sources: www.hedgeindex.com and www.hfr.com Early Results: “Investable” Hedge Fund Products Appear to Lag Hedge Fund Indices

Sources: “Why Accurately Replicated Hedge Fund Indices Won’t Do You Much Good”, March 3, 2007 by Professor Harry Kat, Cass Business School, City University (London) Governance Alignment and Implementation

Investment Investment Committee Staff Do investment committee members have…? □□ …Time and energy to practice the art of contrarian thinking? □□ …Patience for long term orientation? □□ …Informed give and take communication with staff? Diversification approach preference: □□ Traditional 60/ 40 – “Keep it Simple” □□ Top-down “Style Diversifiers” □□ Risk budget controlled – “Quants” □□ Bottom-up best talent driven – “Pioneers” Defined accountability for hiring/ firing/ sizing/ rebalancing decisions: □□ Committee-driven □□ Staff-driven □□ Dual: Staff-driven direct investment and intermediary-driven □□ Intermediary-driven (consultant, fund of hedge fund, etc.) For sourcing, selecting and monitoring top managers, does comm. and staff have…? □□ …Time, interest and access in targeted hedge fund strategies? □□ …Wide breadth of investment capabilities and experiences? □□ …Accurate and timely risk measurement/ performance attribution? □□ …Open dialogue with current and prospective managers? Due Diligence Key Areas of Focus

– Consistent integrity and compliance with the spirit and letter of securities law and regulation – Identifiable and sustainable edge over competition – Mature teams that have been seasoned through several market cycles – Teams that have a balance between operating and capital market skills – World class risk measurement and risk management capabilities – Alignment of interests with investors 3. Hedge Fund Portfolio Construction Michael Norris, Associate Director and Portfolio Manager Bear Stearns Asset Management Portfolios of Hedge Funds

• Framework for constructing a portfolio of hedge funds • Blend of qualitative and quantitative techniques Considerations

• Diversification • Manager Selection • Investment policy statement (“IPS”) • Role of optimization • Risk management • Ongoing monitoring and rebalancing Hedge Fund Strategies

• Directional • Non-Directional – Equity Hedge – Convertible Arbitrage – Event Driven – Fixed Income Arbitrage – Distressed – Merger Arbitrage – Global Macro – Equity Market Neutral – Emerging Market – Relative Value – Managed Futures – Mortgage Backed –Short Bias Securities Importance of Manager Selection

There also is significant variability within strategies, due to different investment approaches, leverage, and manager skill. Convertible Bond Arbitrage as an example Convertible Arbitrage Case Study

30% 5th to 25th Percentile 25% 50th to 25th Percentile 75th to 50th 20% Percentile 95th to 75th Percentile 15% ------Percent Return Percent 10% Fund2

S&P 500 5% w/dividends HFRX Convertible Arbitrage 0% 1 M Q 6 M YTD 1 Y 2 Y 3 Y Fund Name Alpha Ann Alpha Beta R T-Error Fund 1 1.02% 12.95% 1.15 0.85 4.71% Fund 2 0.81% 10.16% 1.30 0.91 3.83% Fund 3 0.57% 7.06% 0.92 0.75 3.84% Fund 4 0.32% 3.91% 0.94 0.90 2.15% Fund 5 0.38% 4.66% 1.22 0.89 2.86% Fund 6 0.38% 4.66% 1.15 0.87 2.77% Fund 7 0.29% 3.54% 1.53 0.84 4.80% Portfolio Construction in the Investment Process

Investment Policy Statement

Portfolio Construction Rebalancing Plan

Portfolio Review Revisit Manager List

Qualitative Review Market Factor Exposure Value at Risk (“VaR”) Performance Analysis Monte Carlo Simulation Risk Analysis Stress Testing/Scenario Benchmarking Analysis Liquidity Analysis

Risk Aggregation Implementation Plan Ongoing Monitoring Common Policy Elements

•Objectives •Constraints – Return goal (maximize total – Strategy & Sub-strategy return) – Manager & Fund – Risk budget – Minimum assets under (half volatility of S&P) management – Downside risk (Maximum probable – Minimum track record loss of 8%) – Liquidity – Low correlation with traditional asset –Tax classes (low beta to equity markets) Role of Optimization

• Drives allocations to qualitative limits ~ provides useful perspective • Extremely sensitive to assumptions • Two stage optimization – Strategy – Fund • Mean-variance vs. downside risk • Common sense Optimization Difficulties

• Quantitative • Qualitative – Lack of Historical Data – Biases in hedge fund data – Style drift – Financial innovation – Non-linearity and non- – Operational and business symmetry of returns risks – Illiquidity and smoothed returns Risk Analysis

• Risk factor sensitivity • Value at Risk (VaR) • Stress Testing • Scenario Analysis

Importance of risk transparency Ongoing Monitoring

• Portfolio review against objectives • Review in context of total portfolio • Revisit constraints • Revisit manager list • Rebalancing plan Survey Question

• How important is risk transparency? -I am happy as long as I get returns -I want returns and regular risk reporting from the manager -I want full transparency from a third party 4. Fixed Income Hedge Funds Heather Malloy Managing Director Bear Stearns Asset Management Fixed Income Hedge Fund Strategies

– Relative Value Arbitrage – Fixed Income Arbitrage – Distressed – Emerging Markets – Mortgage Backed Securities – Synthetic Credit Arbitrage Framing Expectations

What are the sources of returns? -“Cash and Carry” -Realized Gains -Unrealized Gains What are the sources of risk? -Interest rate, credit, -Pre-payment, volatility, currency Framing Expectations

How do we quantify risk? -Relative market exposures -Option adjusted and key rate durations -Spread duration -Convexity/volatility duration

How is risk managed? -Process driven -Derivatives strategies Survey Question

• Are you invested in any of these strategies? – Relative Value Arbitrage – Fixed Income Arbitrage – Distressed – Emerging Markets – Mortgage Backed Securities – Synthetic Credit Arbitrage Fixed Income Hedge Fund Strategies Covered Today

- High Yield - Relative Value Arbitrage - Emerging Markets i. High Yield Leon Wagner Chairman GoldenTree Asset Management, LP High Yield Overview

– Bonds rated below Investment Grade (below BBB-) – Managers invest in non-investment grade debt with emphasis being placed on assessing credit risk of the issuer – Asymmetric return profile – build in large margin of safety – must always be right on credit – Look at entire capital structure - bank debt, high yield bonds, distressed debt, middle market loans, equities and real estate. High Yield Overview

– Objectives may range from high current income to acquisition of undervalued instruments – but always manage for total return – Diversification but overweight best ideas – Quick to sell High Yield

US High Yield Market Size (Dollars in Millions)

1000.0

900.0

800.0

700.0

600.0

500.0

400.0

300.0

200.0

100.0

0.0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: JPMorgan, CSI High Yield Research High Yield

Historical Returns 50.0% 43.8%

40.0% 36.3%

28.7% 30.0% 27.5% 20.3% 18.9% 19.6% 20.0% 15.6% 16.7% 11.4% 13.0% 12.4% 11.5% 11.5% 10.4% 9.4%

Annual total return 10.0% 6.5% 4.3% 5.5% 3.4% 2.1% 3.1% 3.0% 0.4% 1.0% 0.0% -1.6% -10.0% -6.4% -5.8% 2004 2005 2006 2007 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: JPMorgan High Yield

Historical Returns

180.00% High Yie ld 5-Yr. Avg = 10.55%

160.00% HFRI Index 5-Yr. Avg = 9.64%

140.00%

Lehman Aggregate Bond Index 120.00% 5-Yr. Avg=4.86%

100.00%

80.00% Dec-01 Feb-02 Apr-02 Jun-02 Aug-02 Oct-02 Dec-02 Feb-03 Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04 Aug-04 Oct-04 Dec-04 Feb-05 Apr-05 Jun-05 Aug-05 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06

Source: HFR 2006-Q4 Industry Report, Bloomberg and Yahoo Finance. Lehman Aggregate Index approximated via Barclays Global Investors Bond Index High Yield Performance

• High yield’s performance has been led by solid fundamentals and strong technicals • 2006 returns for high-yield bonds have outperformed most other asset classes • 2007 YTD Merrill Lynch High Yield Master II Index (as of 3/31/07): +2.72%

High yield has been a strong performer in 2006 15.80% 16.00% 14.00% 12.00% 11.45% 9.88% 10.00%

8.00% 6.77%

Total return 6.00% 4.29% 4.00% 2.00% 1.44% 0.00% S&P 500 JPMorgan Global JPMorgan EMBI Leverged Loans JPMorgan JULI 10-year Treasury High-Yield Index Global Composite High-Grade Index

Source: JPMorgan Who owns High Yield?

Hedge Funds and Other 7.4% High-Yield Mutual Funds Foreign 14.2% 7.4%

Equity and Income Funds 6.0%

Investment-Grade Funds Insurance Companies 11.9% 25.3%

CBOs 7.9%

Pension Funds 20.0%

Source: JPMorgan High Yield – Use of Proceeds

Other 2.7% General Corporate 13.5%

Acquisition financing-related issuance 48.5%

Refinancing-related issuance 35.3%

Source: JPMorgan European Market

LBO demand has helped create the Leveraged Loan market… European Market

However, the European credit market diverges for large vs. small deals… Large LBO deals are typically financed by large CLO buyers…

Primary Market for Institutional Loans by Investor Type: 2005 Market Weight Profile by Amount Outstanding, Europe: 3/31/2006

Whereas small deals must offer substantial excess return to attract capital:

Credit Suisse Western European Leveraged Loan Index, April 28, 2006: Average Spread All Loans Widest 25, larger than 300M Widest 25, 300M and smaller 296 bps 336 bps 623 bps High Yield Spreads

1200bp 1100bp Long-term average 1000bp (1987 - ytd 07)=

900bp 543bp 800bp 700bp 600bp Spread to Worst 500bp 400bp 300bp Mar-07 312bp 200bp Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Source: JPMorgan Spreads will widen when earnings growth slows…

1200bp Long-term average 100 1100bp (1987 - ytd 06)= Average from 1994 90 1000bp 543bp through mid-1998= 80 379bp 900bp 70 800bp 60 700bp 50 600bp 40

Spread to Worst Spread 500bp 30 400bp 20 300bp Mar-07 312bp 10 200bp 0 Jun-06 Jun-05 Jun-04 Jun-03 Jun-02 Jun-01 Jun-00 Jun-99 Jun-98 Jun-97 Jun-96 Jun-95 Jun-94 Jun-93 Jun-92 Jun-91 Jun-90 Jun-89 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Dec-99 Dec-98 Dec-97 Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 JPMorgan Global High-Yield Index Rolling 4-Qtr S&P 500 Operating EPS

Source: JPMorgan Increase in default rates follows higher issuance of lower quality debt

60.0 Lower rated new issuance 56.0 55.6

Defaulted debt Leads to increased 50.0 defaults 40.0 Increased lower rated new issuance 31.0 32.6 31.1 28.3 30.0 24.9 ($ bn) 22.3 22.5 17.7 18.5 20.0 15.3 11.6 8.6 7.9 8.3 7.6 7.6 8.6 7.3 10.0 5.9 4.3 5.3 3.4 2.3 0.1 0.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 YTD07

Source: JPMorgan Acquisition financing/LBO as a percent of total issuance, generally leads to quicker defaults

Acquisition financing/LBO as a percent of total issuance 60%

48% 50% 44% 40% 38% 30% 28% 30% 27% 26% 26% 20% 21% 20% 16% 15% 13% 13% 10% 3% 4% 3% 0% 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 YTD07

Source: JPMorgan ii. Relative Value Arbitrage John Tsai Portfolio Manager JWM Partners, LLC Relative Value Arbitrage Overview

•Description

– Managers attempt to take advantage of relative pricing discrepancies – Managers invest in instruments including equities, debt, options and futures – Managers may use mathematical, fundamental, or technical analysis to determine misvaluations

Source: Adopted from HFR 2006-Q4 Industry Report Relative Value Arbitrage

Assets Under Management (Dollars in Billions)

$200.0 $188.8 Relative Value Arbitrage 5-Yr. CAGR = 52.2%

$150.0

$130.5 $121.5

$98.6 $100.0

$74.3

$50.0

$23.1

$0.0 2001 2002 2003 2004 2005 2006 Source: The Barclay Group Relative Value Arb.

Source: HFR 2006-Q4 Industry Report Relative Value Arbitrage

Historical Returns

160.00% HFRI Index 5-Yr. Avg = 9.64%

Relative Value Ar 5-Yr. Avg = 7.79% 140.00% S&P 500 5-Yr. Avg = 6.19%

120.00% Lehman Aggrega Bond Index 5-Yr. Avg=4.86%

100.00%

80.00%

60.00% Dec-01 Feb-02 Apr-02 Jun-02 Aug-02 Oct-02 Dec-02 Feb-03 Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04 Aug-04 Oct-04 Dec-04 Feb-05 Apr-05 Jun-05 Aug-05 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06

Source: HFR 2006-Q4 Industry Report, Bloomberg and Yahoo Finance. Lehman Aggregate Index approximated via Barclays Global Investors Bond Index Relative Value Arbitrage US Mortgage Example

Fannie Mae Mortgage versus US Treasury

US Treasury – Full faith and credit, principal repaid at maturity

Fannie Mae Mortgage – Generic, Residential Mortgage “backed” Cash flows “passed through” to investors Cash flows risky, guaranteed by Fannie Mae, not US Treasury Cash flows include interest and principal Monthly payments of Principal and Interest Principal Prepayments – Sale, Refinancing, Early repayment Relative Value Arbitrage US Mortgage Example

Projected Fannie Mae Mortgage Cash Flows Cash flow

Time Relative Value Arbitrage US Mortgage Example

More about Fannie Mae Mortgages

US Treasury Rate = T Fannie Mae Mortgage Rate = T+110 basis points

Why does the Fannie Mae Mortgage have a higher rate? Default Risk – Investor receives less than promised payments Interest Rate Risk – Principal Prepayments Refinancing – Interest Rate Dependent Voluntary Prepayments – Interest Rate Dependent Sale – Interest Rate Independent Relative Value Arbitrage US Mortgage Example Valuing the Fannie Mae Mortgage US Treasury Rate = T Fannie Mae Mortgage Rate = T+110 basis points What should be the yield spread? Model Interest Rates over time Model Default Losses over time Model Prepayments based on Interest Rates Compute “Expected NPV” of Mortgage Payments Compare Market Price (observed) to Expected NPV Market Price Higher – Mortgages too expensive (rich) Market Price Lower – Mortgages “cheap” Relative Value Arbitrage US Mortgage Example

Fannie Mae Mortgage Option Adjusted Spread Over Treasuries OAS

Time iii. Emerging Markets Fran Rodilosso Managing Director, Greylock Capital Management LLC Emerging Markets Overview

Description:

– Invest in currencies, debt instruments, equities and other instruments of “emerging” market countries

– Emerging Markets include countries in Latin America, Eastern Europe, Africa, and Asia

– Many of the alternative strategies employed in developed markets are applicable to emerging markets, although emerging markets offer a unique risk environment. Originally, the only practical approach focused on EM debt, but now managers can employ strategies over a number of sub-sectors, including arbitrage, credit and event driven, L/S equity, distressed, and even private equity.

Source: Adapted from Credit Suisse/Tremont. Why Invest in Emerging Markets?

Several Reasons that Investors Choose Emerging Markets:

1. Diversification. Historically low correlation to G-7 assets. 2. Growth story. Potential for rapid appreciation of assets. 3. Valuations. Due to a wide variety of risk factors, EM assets have always appeared ‘cheap’ relative to comparable G-7 securities. 4. Asymmetric information. Less followed markets are less efficient, giving active managers a chance to add value. Nimble alternatives managers can capitalize upon these inefficiencies and add significant value through techniques and trades that are often crowded-out in developed markets. Emerging Markets

Assets Under Management (Dollars in Billions)

$100.0

Emerging Markets 5-Yr. CAGR = 27.8% $80.0

$62.6 $60.0

$44.5 $40.0 $32.0

$22.3 $18.4 $20.0 $13.4

$0.0 Source: The Barclay Group 2001 2002 2003 2004 2005 2006 Emerging Markets

Source: HFR 2006-Q4 Industry Report Emerging Markets

Historical Returns

260.00% Emerging Markets 5-Yr. Avg = 20.82%

210.00%

HFRI Index 5-Yr. Avg = 9.64% 160.00% S&P 500 5-Yr. Avg = 6.19% Lehman Aggregate 110.00% Bond Index 5-Yr. Avg=4.86%

Source: HFR 2006-Q4 Industry Report, Bloomberg and Yahoo Finance. Lehman Aggregate Index approximated via Barclays Global Investors Bond Index Investment Process

Top Down Combines with Bottom Up: In emerging markets, if you get the country wrong, it often doesn’t matter what you choose for an underlying security

Top Down: To set up regional, country and sector allocations – Macro analysis of interest rates and asset flows – Macro call on country

Bottom Up: To find the best reward/risk at the investment level – Knowledge of local markets, customs and laws – Familiarity with and understanding of management – Willingness to Pay – Solid credit work – Ability to Pay – Financial engineering/structuring – Negotiating with management and government leaders

Portfolio Management: Diversification, hedging, managing liquidity Emerging Markets: Trade Example

Debt investment with equity warrants in a company attempting to consolidate the oil services sector in Siberia Decision inputs: – Positive outlook on Russian oil services industry and the country’s intent on growing its resource infrastructure – Founder with strong track record of successful investing in Russia – CEO a Russian national and industry insider – Excellent business plan Risk Considerations: – Politics and corporate governance in Russia – Execution of business plan Key to Investment Decision: – Deal structured to offer upside more than commensurate with the risks Emerging Markets: Trade Example

Deal: – $14mm loan at high-teens interest rate – Detachable warrants, exercisable upon IPO, struck at US$20/share – Callable at premium to par – Strong covenant package –UK law

Results: – Debt called at a premium (110%) – IPO took place in February at $335/share, two years after investment 5. Fixed Income Historical Returns Francie Heller, Senior Managing Director Bear Stearns Pension, Endowment, and Foundation Services Fixed Income and International Hedge Fund Strategies Assets Under Management (Dollars in Billions)

$600.0 Total Total $541.5 $12.3 5-Yr. CAGR = 30.4% $29.8 $500.0 Total $41.4 Total $402.5 $358.2 $62.6 $400.0 $8.7 $29.1 Total $6.7 $28.4 $62.8 $296.9 $25.6 $25.4 $44.5 $300.0 $5.4 $20.0 $32.0 Total $18.1 $51.9 $156.0 Total $204.2 $22.3 $46.3 $143.6 $4.8 $35.6 $200.0 $15.8 $118.1 $12.9 $13.4 $107.4 $5.7 $29.3 $102.5 $4.8 $18.4 $5.8 $58.5 $100.0 $14.4 $188.8 $71.4 $121.5 $130.5 $98.6 $74.3 $23.1 $0.0 2001 2002 2003 2004 2005 2006 Relative Value Arb. Macro Distressed Securities Emerging Markets Fixed Income Arbitrage Mortgage Backed High Yie ld

Source: HFR 2006-Q4 Industry Report Fixed Income and International Hedge Fund Strategies Historical Returns

260.00% Em e r g in g M ar k e t s

220.00%

Distressed

180.00% High Yie ld Macro Mortgage Backed Relative Value Arb 140.00% Fixed Income Arb

100.00% Dec-01 Feb-02 Apr-02 Jun-02 Aug-02 Oct-02 Dec-02 Feb-03 Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04 Aug-04 Oct-04 Dec-04 Feb-05 Apr-05 Jun-05 Aug-05 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06

Source: HFR 2006-Q4 Industry Report 6. Summary of Asset Allocation Gregory J. Dyra Assistant Treasurer, Vanderbilt University (2004- January 2007) Portfolio Manager, Northwestern University (1996-99) Inv. Operations Manager, Northwestern University (1993-96) Summary of Asset Allocation

• The endowment universe continues to increase allocations to hedge funds which have historically had attractive returns and delivered diversification • Institutional investors vary widely in their approach to diversifying their portfolios • Many institutional investors treat hedge funds as an asset class despite large dispersion, even within strategies • Benchmarking practices vary but most popular is 90-day Treasury Bills + 5% • Investors should beware of the quality of in-house risk measurement systems, diminishing returns of hedge fund universes and investable indices which lag the composite indices Survey Question

How would you characterize your organization’s approach to hedge funds? -Investment committee and staff view hedge funds as an asset class -Investment committee and staff do not view hedge funds as an asset class -Investment committee and staff differ 7. Questions Future Programs

• 5/3/07 Alternative Strategies Thank You NACUBO and Bear Stearns thank you for participating. Please share your feedback by completing the online evaluation.