Absolute Return Strategies

REPRINTED FROM NOVEMBER 19, 2007 Absolute Return Strategies WILLIAM E. FLAIG JR., Chief Investment Officer at Arrow Investment Advisors, LLC, joined the firm in February 2007. He spent five years at Rydex Investments, working as Director of Portfolio Management, in which he managed the entire portfolio team. While at Rydex, Mr. Flaig defined the concept of hedge fund replication, initiated the research and investment strategies on which the Rydex Absolute Return Strategies Fund and the Rydex Hedge Equity Fund are based, and directed those strategies. He also developed best practices for creating leverage within the constraints of a mutual fund offering unlimited trading. Prior to Rydex, he spent six years at Bankers Trust Company in a range of roles including currency trading, proprietary trading, derivatives structuring, emerging market fixed-income, and currency trading. He graduated from Purdue University with a degree in Management. TWST: Please start with an overview of Arrow ponents to the recent sale of Rydex. I met this team when I was Funds. Tell us all about its investment philosophy and what the Director of Portfolio Management at Rydex. I joined Arrow you do there. Funds earlier this year, in the capacity of Chief Investment Offi- Mr. Flaig: Arrow Funds is one of the fasting growing cer, with a mandate to enhance the firm’s manufacturing capabil- investment management companies in the industry. The company ity of absolute return strategies and oversee other investment was formed in early 2006 and launched its first product, the initiatives. Absolute return strategies aim to produce positive re- Arrow DWA Balanced Fund, in August of that year. We’ve had turns in as many environments as possible. great success with that product — it exceeded $100 million in In a declining market, successfully implemented abso- AUM right after its one-year anniversary. Over the last year, the lute return strategies aspire to provide positive returns, or to avoid Fund has continued to outperform 90% of the funds in the Morn- or hedge market risk. To this end, absolute return strategies may ingstar moderate asset allocation category. use hedging, short selling, or for arbitrage or other positions less Arrow’s vision is to manufacture and distribute alterna- dependent on broad market direction. In a declining market, a tive investment solutions for financial intermediaries and their relative return strategy, which is designed to track an index, will clients. The Arrow founders are made up of the original product track the index down — the manager, who typically has a man- development team at Rydex Investments. They worked together date to stay invested, hopes to marginally outperform on the for a number of years as a team, developing and distributing mu- downside. Conversely, in a rising market, the relative return man- tual funds, ETFs, variable trust funds and WRAP programs. The ager benefits from the rising tide of its asset class. The manager business lines and products they created were instrumental com- may or may not participate in such a rise, depending on whether MONEY MANAGER INTERVIEW MONEY MANAGER INTERVIEW ——————— ABSOLUTE RETURN StrategieS his strategy is correlated to or hedged against the rising asset tive investment process. Also, I extensively researched and class, and whether or not the sources of the absolute return strat- developed the concept and framework for Rydex’s hedge fund egy’s returns and risk are related to that asset class. replication strategies. Absolute and relative returns are different from each I left Rydex to research and develop a better alternative other and widely varied among themselves. Stock and bond value proposition. While the roots of my replication research funds, while both relative return strategies, are as different from helped, I’ve spent the last 18 months developing another alterna- each other as long/short equity are from fixed income arbitrage tive approach. The Arrow Alternative Solution Fund is a major among absolute return strategies. We plan to deliver 1940 Act step forward because it combines some of the principles of hedge products that make use of these differences. By doing so, we will fund replication with modern portfolio theory. At Arrow, I’ve provide mutual fund investors with an array of tools comparable developed several absolute return factors, which go beyond tradi- to that available to institutional investors. We would love to put tional investment methodologies because they attempt to reduce the mutual funds on a more equal footing with endowments by correlation to the risk of a given asset class. providing similar product objectives and nontraditional sources Whether or not to favor relative return factors or abso- for returns, greater opportunities for diversification and tools for lute return factors, and how to apply those factors, are questions risk management. Our first absolute return strategy vehicle is strongly influenced by the efficient market debate. I believe that called the Arrow Alternative Solutions Fund. the bulk of traditional returns are driven by exposure to relative “The Fund’s principle investment strategy seeks to maximize returns from a diversified portfolio of three long and short strategies with a targeted risk objective. We are looking to achieve a total rate of return that meets or exceeds 10% per year after management fees over a rolling three- to five- year time horizon, with a risk target of 7% as measured by annual standard deviation, and a beta to the S&P 500 of less than 0.5.” TWST: Tell us about some of these alternative invest- return factors. Because a relative return factor behaves with high ment strategies that you brought to the firm and how that ties correlation to and within its asset class, it has no mechanism to in with the Aternative Solutions Fund. control downside risk during cyclical negative market periods. Mr. Flaig: I will speak to my background a little bit Therefore, relative return factors contain market risk. Tradition- before I go into that. Prior to working at Rydex, I had extensive ally, investors have attempted to mitigate the risk inherent in experience at Bankers Trust with investment strategies and assets relative return factors by creating diversified portfolios, which that ran the gamut from fixed income, equities, global fixed in- may allocate between stocks and bonds, between domestic and come, and currencies to derivatives trading and structuring. This international stocks, between growth and value stocks, or be- helped me acquire insight and expertise into the instruments used tween stocks of different capitalization ranges and different sec- in alternative strategies. My experience at Rydex, which is pri- tors. I believe that the ultimate goal of diversification — to marily an equity indexing shop that uses derivatives extensively, combine assets that move independently of one another — has afforded the opportunity to hone the practical application of these not been satisfactorily achieved by traditional approaches. My instruments for mutual funds. As the Director of Portfolio at approach combines these absolute return factors to create a core Rydex, I was responsible for the management of $10 billion alternative portfolio. This kind of portfolio construction is opti- spread over several unique investment strategies. I was signifi- mal for seeking absolute returns and capital appreciation with cantly involved in building and then refining the firm’s quantita- low volatility and low correlation to the equity markets. MONEY MANAGER INTERVIEW ——————— ABSOLUTE RETURN StrategieS The Fund’s principle investment strategy seeks to maxi- This orientation has proven costly, especially since 1999. The fu- mize returns from a diversified portfolio of three long and short ture demands a more varied investment approach in order to pre- strategies with a targeted risk objective. We are looking to serve and enhance capital for a generation of investors. achieve a total rate of return that meets or exceeds 10% per year The Arrow Alternative Solutions Fund seeks to combine after management fees over a rolling three- to five-year time ho- the best features of hedge funds and mutual funds. Some of the rizon, with a risk target of 7% as measured by annual standard shared characteristics compared would be that hedge funds and deviation, and a beta to the S&P 500 of less than 0.5. As with any long/short mutual funds are both seeking absolute returns — that fund, let me state that we do not represent or guarantee that the is, positive returns regardless of the market environment — while Fund will meet these goals. traditional mutual funds are generally just seeking returns relative “The Arrow Alternative Solutions Fund is a mutual fund structure with hedge fund features. Hedge funds have long been highly regarded for their use of alternate strategies and investment techniques. However, the structure of the hedge funds themselves often raises concerns for investors. Historically, the mutual fund industry has been oriented to long-only investing. This orientation has proven costly, especially since 1999. The future demands a more varied investment approach in order to preserve and enhance capital for a generation of investors.” TWST: The Alternative Solutions Fund seems to to benchmarks that have periods of outperformance and underper- combine features of mutual funds and hedge funds. Is that formance. Traditional mutual funds typically have high correla- correct and, if so, what are the differences? tions to equity and bond markets while the Arrow Alternative Mr. Flaig: You’re correct, the Fund does combine fea- Solutions Fund and hedge funds have low correlations to equities tures of mutual funds and hedge funds. The markets are a catalyst and the bond market. Mutual funds are highly regulated with over- for change and so is market regulation. The mutual fund industry sight from the SEC, while hedge funds operate in an environment is always looking for way to preserve its own income stream as with far less regulation.

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