Absolute Return Strategies

REPRINTED FROM november 19, 2007

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. Mutual funds have restrictions on leverage, well as investor capital. Their foray into the hedge fund space illiquid securities, and derivatives; limitations on incentive fees; started in 1997 when Congress repealed the mutual fund short- and protective custody requirements. These restrictions keep some short rule. Congress believed it would be in the public interest if of the problems found in the hedge fund away. Mutual funds are mutual funds could trade (and hedge) more broadly and effectively. highly transparent and they offer liquidity through the daily NAV. Rydex delivered the first inverse strategies that were tied to indices Most hedge funds pride themselves on not being transparent and like the S&P 500. These funds became great hedging tools for the they limit the frequency of investor redemptions. Another major tactically proficient investor. Other manufacturers created dedi- difference is the structure of managers’ compensation. Mutual cated long/short strategies and now some are utilizing strategies fund companies charge fees from 1% to 4.5% on the amount of designed to mirror the performance of hedge fund indices. assets under management, regardless of performance (in the case More specifically, the Arrow Alternative Solutions Fund of the Arrow Alternative Solutions Fund, the fee is 1.52%). Most is a mutual fund structure with hedge fund features. Hedge funds hedge fund companies charge flat management fees of 1% to 2% have long been highly regarded for their use of alternative strategies based on the total assets under management plus 20% to 25% in- and investment techniques. However, the structure of the hedge centive fees. Aside from the hedge funds’ high fees and lack of funds themselves often raises concerns for investors. Historically, oversight, the next biggest barriers to purchase are investor qualifi- the mutual fund industry has been oriented to long-only investing. cations and high minimums. MONEY MANAGER INTERVIEW ——————— absolute return strategies

Hedge funds are restricted to accredited investors and equity strategy will provide exposure to eight absolute return fac- they typically have investment minimum that range between tors (e.g. long/short value). The Fund could have between 40% $100,000 to $1,000,000. Mutual funds are open to all investors. and 60% exposure to this strategy. While most funds do have minimums, these minimums range The fixed income arbitrage strategy seeks to generate between $1,000 and $10,000. Our Fund’s non-qualified mini- returns from relationships between different fixed income securi- mum is $5,000 and $2,000 for retirement accounts. ties, employing long and short positions to minimize exposure to

“The Alternative Solutions Fund provides exposure to three long/short strategies, including hedged equities, fixed income arbitrage and managed futures. The goal of each long/short strategy is to systematically identify and provide exposure to absolute return factors on an ongoing basis. The hedged equity strategy seeks to generate returns from investing on both the long and short sides of equity markets while maintaining a low correlation to the US equity market.”

Offering a more diversified and robust portfolio that can interest rate changes that are either mathematically or historically preserve and enhance capital over time in all market environ- interrelated. The strategy will provide exposure to five absolute ments is something that only a very few have had access to in the return factors (e.g. high yield credit spread). The Fund could have past. The Arrow Alternative Solutions Fund was designed so that between 20% and 45% exposure to this strategy. all investors can have access to a low cost, highly diversified The managed futures strategy seeks to generate returns absolute return strategy. It’s indeed the best of both worlds. from convergent and divergent trends in the commodity, financial TWST: Tell us about the allocation of your different and currency futures markets. The Fund could have between 20% strategies and the composition of the Fund? and 30% exposure to this strategy. The managed futuresstrategy Mr. Flaig: The Arrow Alternative Solutions Fund pro- will provide exposure to four absolute return factors (e.g. long/ vides exposure to three long/short strategies, including hedged short commodity sector relative strength). The allocation among equities, fixed income arbitrage and managed futures. The goal the strategies is determined with a portfolio optimization tool to of each long/short strategy is to systematically identify and pro- maintain targeted risk of 7%. vide exposure to absolute return factors on an ongoing basis. The The Fund has several long/short portfolios but there is hedged equity strategy seeks to generate returns from investing ultimately an underlying investment rationale that supports why on both the long and short sides of equity markets while main- the absolute return factor has historically had positive perfor- taining a low correlation to the US equity market. The hedged mance and why we would expect that performance to continue in

Absolute Return Factors for each Strategy the future. I speak to this in a white paper that we’ve developed, and each investment rationale is supported by industry practice and academic research. TWST: Do the three long/short investment strategies, your three buckets, all include the absolute return factors you mentioned previously? M O NMONEY E Y M AMANAGER N A G E R INTERVIEW I N T E R V I E——————— W ——————— absolu invete rets tingurn s trategiein s tosc k s

Mr. Flaig: They do. Since absolute return factors are solute return factor, but when an investor buys value or buys being pioneered by Arrow Funds and it’s not a widely publicized small cap he is also just getting equity market risk or equity risk concept, I think it would be helpful to explain what they are. premium as well in his investment. You will still have years Absolute return factors go beyond traditional invest- where even a value holding or a small cap holding will lose ment methodologies in an attempt to reduce correlation to the money if the overall equity market is down. The return is al- risk of their asset class. The objective is to deliver the return of ways going to be relative to that equity risk premium and if you a particular investment style, while reducing that style’s overall look at the correlation to the S&P 500, value and size investing and market risk, thus reducing portfolio volatility over time. is high—higher than 0.8 and very likely higher than 0.9. The We use a quantitative methodology to identify two subsets Fund’s long/short portfolio construction and the absolute return within each absolute return factor: those assets expected to factor philosophy are applied to a value basket. The absolute outperform the asset class, which are held long; and, those ex- return factor that provides exposure to value will buy value pected to underperform the asset class, which are sold short. stocks just like traditional investors but we simultaneously pur- This long/short portfolio construction attempts to minimize chase a portfolio of non-value stocks against the long basket. the risk of substantial losses stemming from market declines What is produced is the absolute return of value and not while reducing volatility. the relative return of value. By doing that, we are reducing the

“The managed futures strategy seeks to generate returns from convergent and divergent trends in the commodity, financial and currency futures markets. The Fund could have between 20% and 30% exposure to this strategy. The managed futures strategy will provide exposure to four absolute return factors (e.g. long/short commodity sector relative strength). The allocation among the strategies is determined with a portfolio optimization tool to maintain targeted risk of 7%.”

Each absolute return factor is tied to a very common equity exposure, emphasizing the value exposure in a more pure hedge fund strategy. The long/short value is an absolute return way. This is the simple building block behind the Fund’s absolute factor in the Fund’s hedged equity strategy. I use this as an illus- return factors. tration because almost all investors have a value exposure in their This long/short portfolio construction is applied to portfolio. Another very commonly held exposure in portfolios is many of the same traditional investment styles that are used by size. This is based on research done by many, but particularly investors today. The Fund will be long a broad mix of finan- Fama and French, who validated the idea that value and small cial asset classes, including equities, fixed income, currencies companies historically outperformed the marketplace. The ratio- and commodities. The Fund will be short the same broad mix nale for why they outperformed the overall market is that an in- of financial asset classes using derivatives. Most long/short vestor is taking more risk in a value company or a small cap strategies focus on one or multiple absolute return factors. company. The investor is compensated for this greater risk with a Some focus on just equities, fixed income or commodities. greater return, so risk reward supports why investors, from an The individual exposures are rarely combined. However, academic standpoint, include value in their portfolios and why hedge fund of funds strategies will combine them. How they investors include small cap in their portfolios. are combined is their downfall. Isolating those traditional in- Since the early 1990s, this has been a generally ac- vestment styles into a corresponding absolute return factor is cepted investment philosophy and people have been allocating critical to our approach. Our value proposition is how we com- to these styles accordingly. That’s the starting point for an ab- bine these factors. M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E——————— W ——————— absolu invete rets utingrn strategie in s tosc k s

TWST: How are you able to get a performance re- return when compared to traditional assets. The beta to the S&P cord for such diverse strategies? What is the comparison you 500 over that time period was about a 0.13, and a .46 Sharpe ratio. use to measure performance? What was really telling was how the strategy performed over the Mr. Flaig: I spent the last 18 months testing each ab- worst and best three year period since 2000. Between April 2000 solute return factor. I have elaborated on this in a white paper. and March 2003 the S&P 500 lost an annualized 16.1% with a In the paper, we use only third-party data to be able to test the standard deviation of more than 17%. During that time period, the strategy both historically and transparently. Because of data alternative strategy was up about 13%, again, with a 6.3% standard quality, we limited the overall backtest, but I have personally deviation. Between April 2003 and March 2006 the S&P 500 was tested equity absolute return back to 1927. There are obvious up 17% annualized with a standard deviation of 8.8%. During that data limitations on the fixed income and commodity data set for time period, the alternative strategy was close to 13%, again, with our testing, but we backtested the Fund’s strategy with third- a 6.5% standard deviation. While the S&P 500 was nearly flat over party data back to 1995. Because there are practical limits that the combined period, the Arrow Alternative Strategy annualized come with third-party data, we produced our own proprietary return was more than 12% and less risk and very little correlation. historical return stream for each absolute return factor. This In an environment when the S&P 500 is doing very well or an data set was created to help our implementation and manage- environment when the S&P 500 is doing poorly, this Fund’s back- ment of the Arrow Alternative Solutions Fund. We are also tested performance has been stable. We’ve seen strong returns with happy to report that the conclusions were essentially the same a very controlled level of risk and a low beta to the S&P 500. So when we compared the two data sets. from a big picture perspective, if you think of a portfolio as the What we’ve created is very exciting. The Arrow Alterna- efficient frontier as we’ve all been taught, adding this strategy to a tive Strategy was tested back to 1995 has offered an annual return portfolio bumps the efficient frontier out to what’s commonly of 14% with a risk of about 6%. This is an excellent risk-adjusted called the northwest quadrant: more return for either the same or less risk to the positive attribute. Historical Look at the Arrow Alternative Strategy If you look at it over a complete market cycle, in years when traditional investments are struggling, this strategy is performing extremely well, and in years when the S&P or bonds are strong, this strategy is also keeping up — it’s still on the efficient frontier. From the diversification standpoint, you are getting strong performance and diversification in bear markets, which is when you need it most, and the cost of doing it is minimal because it’s still on the efficient frontier in strong market environments. M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E——————— W ——————— absolu invete rets utingrn strategie in s tosc k s

TWST: Are there any other risk management tech- terparts. But to round out that picture, it’s necessary to consider that niques that you incorporate into the strategies that you can volatility is not the only measure of risk a client could face. Volatility tell us about? takes into account what normally happens, but it doesn’t reflect just Mr. Flaig: I would like to keep that simple. In our optimi- how far outside the normal distribution the returns can be. For that zation approach, we are targeting a fixed level of risk as opposed to we looked at the risk band — that is, the peak, median and low. an asset-based target. That’s an extremely strong value proposition. The alternative strategy does a satisfactory job of We do have diversification constraints in place to prevent the Fund achieving its 7% risk objective when we evaluated the rolling from piling into one strategy at any given time. We also have the risk three-year average from January 1995 though September 2007. constraint: for an absolute return strategy even to be considered in The risk band is narrower than the equity market and most of the the Fund, it has to have a compelling historical risk towards justifica- hedge fund proxies that we put it against. Looking at the 36- tion supported by research beyond our own institution with a strong month rolling standard deviation and return, we discovered what enough investment rationale that would convince us that the strate- you would expect for the S&P 500. The S&P 500 risk band gy’s compelling performance would continue in the future. ranged between 7.6% and 22.2% with average risk of 16.7% and We have several additional risk controls that are inher- average return of 10.9%. When compared to credit Suisse Trem- ent to mutual funds themselves. Also, from a portfolio construc- ont Hedge Fund Index, the risk band was smaller — 3.1% to tion standpoint, think of the extent that a long/short strategy is 12.9% — but it had lower average risk of 8.4% and slightly lower leveraged. We are buying long exposure that’s greater than the returns of 10.3%. However, the risk band for the alternative strat- Fund’s assets and we’re creating short exposure, which is also egy was tighter and similar to a bond portfolio (between 6% and significant. The level of that overall exposure is constrained so 7.6% with an average risk of 7.1% and a 13.3% return). This was that we can’t get runaway leverage and the amount of net expo- higher than both. The Credit Suisse Tremont Hedge Fund Index sure, which is the long minus the short exposure, has to be below performance was in line with our strategy but its risk band re- 0.8 as well. The Fund has to be long/short and not overly lever- sembled the equity markets — it had a beta of.50 and risk average aged — these risk controls are laid out in the Fund’s prospectus. of 10.3%, similar to a traditional 60% equity and 40% bond port- As mentioned earlier, alternative strategies have posted folio. The average beta for the alternative strategy was 0.16. strong returns with lower volatility than their stock and bond coun- TWST: What gives this Alternative Solutions Fund its edge? What are the defining features that you think makes it Risk Band for Various Market Indicators distinctive compared with other alternative strategies at other firms? Mr. Flaig: The diversification across multiple hedge fund strategies and the specific risk target of 7% are competitive advantages. The Fund is combining three systematic long/short strategies is also an advantage over black-box type construction methodologies used by others. Lastly, the fund is not backward looking — that is, looking at what hedge fund indexes or hedge fund holdings have been. It is only forward-looking in its portfolio construction. M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E——————— W ——————— absolu invete rets utingrn strategie in s tosc k s

Long / Short Portfolio Exposure construction used in this Fund. You should note that a lot of these funds struggled in the volatile market over the summer of 2007. In 120-20 portfolio construction, the manager buys $1.20 of long exposure for every dollar of investor money and creates the 0.2 short exposure. This structure gives the manager leverage to beat a benchmark, but it does not lower portfolio’s correlation to the S&P 500. The portfolio’s 120% long exposure minus 20% short exposure has 100% net long exposure, which is why its correlation to the S&P 500 is higher. Our fund’s portfolio net exposure will not be 100% net long. In fact, historically the strategy will have $1.50 of long exposure and $1 of short exposure — 150% long exposure minus 100% short exposure has 50% net exposure. That is half of the overall market exposure. The net exposure will range between 50% and 80%, which is driven by our optimization process. Tools that provide lower correlation to the traditional equity mar- If I compare those advantages to groups of other alterna- ket are better vehicles to diversify traditional portfolios. tive products in the marketplace, the Arrow Alternative Solutions Most people don’t realize that risk in hedge funds and Fund has better diversification and better risk controls than funds active manager is driven by the parameter of the corresponding that are offering hedge fund replication (that is, a high correlation manger’s opportunity to seek potentially higher returns and not to hedge fund indexes); additionally, it is not a black box and is by the investor’s risk tolerance. not looking backward at hedge fund indexes. The risk-targeting concept can also be thought of as risk When I look at this fund versus hedge funds of funds or rebalancing. Ultimately, an investor’s risk tolerance is fixed over mutual funds that invest in hedge fund subaccounts, the Arrow most time periods and likely decreases as he or she ages, holding Alternative Solutions Fund has superior diversification and risk other variables constant. This is not in conjunction with what controls. We also do not have manager risk or capacity con- most investors actually hold in their portfolios (an asset mix of straints that might exist in some of those funds. 60/40, 40/60 etc.,), which varies widely over time. Many of those funds are allocating to small hedge fund The conventional asset allocation portfolio’s riskiness is managers, a process that does not have scalability. This is be- independent of the investor’s risk tolerance. Regardless of their cause as hedge fund managers get bigger, their performance risk tolerance, investors are taking more risk when the market is tends to deteriorate. Not unlike in the mutual fund space, the riskier and taking less risk when the market is less risky. With the niche is somewhat dependent upon liquidity and small size to be targeted risk approach I propose, the investor is conceptually able to deliver that value proposition. buying more of the relatively riskier assets during periods of low The Arrow Alternative Solutions Fund may not have overall risk and buying more of the least relatively risky assets scalability problems, so it will not have limits as to how much it during periods of high overall risk. can grow without a deterioration of performance. And lastly, TWST: Though this fund might not be suitable for against long/short strategies that are proliferating in the market- all investors, would you give us a description of your typical place, most of them are not diversified; they are actually nar- clients who are interested in alternative strategies? rowly focused on a particular investment style. They don’t have Mr. Flaig: A majority of our investors will be financial diversification, they have manager risks, and a lot them are focus- intermediaries. Most of these intermediaries are turning to tacti- ing on what I would call the, 120-20, 130-30 type of long/short cal and alternative strategies to increase diversification, boost portfolio construction, which is very different from the portfolio returns, and help manage risk. If the investor’s goal is to secure M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E——————— W ——————— absolu invete rets utingrn strategie in s tosc k s higher returns at a lower risk, then integrating the Arrow Alterna- product with a fund with absolute return strategies to create their tive Solutions Fund into a traditional portfolio should help reduce own endowment solution for their clients. portfolio volatility and improve the odds of preserving capital We have selling agreements with more than 200 of the over the long term. top national, regional, independent broker/dealers and registered Allocation to alternative assets is a strategy that many investment advisor-based platforms. Currently, more than 500 endowment managers (e.g. Harvard, Yale) are utilizing today. financial intermediaries are using the Arrow DWA Balanced Prior to 1999, Harvard’s investing was strictly limited to US Fund. We are focused on getting financial intermediaries to fol- stocks, bonds and cash. They recognized they were taking on too low the endowment path of adding “absolute return” assets to much risk and missed out on opportunities with alternative as- their clients’ portfolios. We know that many of them are using sets. Since 1999 they gradually started to shift away from tradi- hedge funds and managed futures strategies for their high net tional assets toward “absolute return” assets. Today, Harvard worth clients. The innovation of blending three alternative strate- allocates 17% toward alternative assets and most endowments are gies within a low-cost mutual fund wrapper allows many of our allocating between 10% and 25%. These asset classes have the clients to finally offer an “absolute return” strategy to investors potential to deliver “equity-like” returns, but since they are not who normally don’t have access to this type of strategy. correlated with US equities, they cushion the portfolio against TWST: Is there anything that you would like to add? losses when the domestic stock market goes through its inevitable Mr. Flaig: Many of our clients ask us how much they down cycles. should move toward alternative strategies. We typically tell our One of our goals is to create value for our clients by offer- clients that the investor’s risk profile should dictate that. How- ing investment strategies that seek to enhance returns and mitigate ever, the risk band of some alternative strategies makes it difficult risk. Our first product, The Arrow DWA Balanced Fund, tactically to pin down a realistic allocation. Then we point the client toward provides exposure to four market segments (US equities, interna- the endowment path. Most endowments have already identified tional equities, fixed income and alternative assets). Our tactical their allocations, which is critical for positioning their school as- core is designed to be responsive to changing market conditions but sets and budgets. Their portfolios need to participate in strong it is missing exposure to “absolute return” strategies. The Arrow upside markets while limiting their exposure to the downside. If Alternative Solutions Fund enables clients to blend our tactical core they fail, the school assets drop and their operating budget is reduced, resulting either in a possible increase in tuition or the need Correlation of Alternative Asset MONEY MANAGER INTERVIEW ——————— absolute return strategies to spend a portion of the endowment base during down markets. bonds provided the support during down markets, it typically does Many advisors need to look at their clients’ portfolios in the same not participate equally when the markets are strong. Our alterna- light. There are 62 endowments funds that manage assets of more tive strategy over the same bull market period was up 12.7% a than $1 billion. Collectively, these endowments manage more year. That is why endowments have reduced their fixed income than $229 billion and allocate 22.4% of their portfolios toward exposure and maintained the same equity exposure since 2002. absolute strategies. Since 2002, that allocation has increased 26% Absolute return strategies are typically not correlated to during a very strong equity market. the movement of traditional assets. The beauty of the Arrow Al- Many of our clients also ask us what component of the ternative Solutions Fund is that it combines strategies that do not portfolio should be reduced. Most optimizers will reduce the exhibit a high correlation to one another, potentially giving the riskier assets like equities. My advice would be to follow what the investor an opportunity to reduce risk without sacrificing returns. smart money is doing. The 62 endowments that we mentioned We believe that in order to realize the benefit of diversification, a earlier have reduced their fixed income exposure by 39% since portfolio’s underlying asset classes must behave differently in 2002. It makes sense. During the last three-year bear market varying market conditions. If the investor’s goal is to secure (April 2000 to March 2003), the S&P 500 was down 16.1% a higher returns at a lower risk, integrating alternatives into a tra- year while bonds were up 9.8%. Our alternative strategy, which ditional portfolio should help reduce portfolio volatility and im- we will use as a proxy for absolute returns, was up 12.9%. Since prove the odds of preserving capital over the long term. This is 1999, the strongest three-year period for the S&P 500 was from the value proposition of the Arrow Alternative Solutions Fund. April 2003 to March 2006. During that period, the S&P 500 was TWST: Thank you. up 17.2% a year but bonds were only up 2.9%. Absolute return strategies are designed to respond in all market conditions. While Note: Opinions and recommendations are as of November 1, 2007.

An investor should consider the Fund's investment objective, risks, charges, and expenses carefully before investing or sending money. This and other information about Arrow Funds is contained in the fund's prospectus, which can be obtained by calling 1-877-277-6933. Please read the prospectus carefully before investing. Arrow Funds is distributed by Aquarius Fund Distributors.

1161-AFD-11/20/2007

The Arrow Alternative Solutions Fund may not be suitable for all investors. The fund’s use of derivatives such as futures, options and swap agreements may expose the fund to additional risks that it would not be subject to if it invested directly in the securities underlying those derivatives. Investing in leveraged instruments will magnify any gains or losses on those instruments. Investing in commodity and currency related securities may be subject to greater volatility than investments in traditional securities. The fund's use of short selling involves increased risks and additional costs. Investing in small-cap securities, may have special risks associated including wider variations in earnings and business prospects than larger, more established companies. The Fund may invest in fixed income securities, which are subject to risks including interest rate, credit and inflation. The maximum sales charge for Arrow’s A-shares is 5.75%. A-share investors may be eligible for a reduction in sales charges. The Fund charges a fee of 1.00% on redemptions of shares held less than 30 days. The Arrow DWA Balanced Fund’s annual operating expense is 2.01%. The Arrow Alternative Solutions Fund’s annual operating expense is 1.52%. MONEY MANAGER INTERVIEW ——————— absolute return strategies

Definitions Volatility is a measure of fluctuations in value based on annualized standard deviation of monthly returns. Beta is a measure of relative risk. Correlation is similarity in performance to the equity markets. Sharpe Ratio measures risk-adjusted returns by taking the return less the risk-free rate, and dividing the result by the standard deviation. Absolute returns are generally positive rerturns in any market environment.

Footnotes The Arrow Alternative Strategy reflects hypothetical or simulated performance figures and is not meant to represent actual performance results for the Arrow Alternative Solutions Fund. Past performance is not indicative of future results. Potential for profit is accompanied by possibility of loss. These figures reflect a simulated portfolio managed with the Arrow Alternative Strategy using actual & hypothetical performance data for various financial instruments based on Arrow Investment Advisors analysis. The simulated model was constructed using their proprietary set of rules for the purchase and sale of securities for each underling strategy as outlined in the Arrow Alternative Solutions Fund prospectus. There can be no assurance that actual transactions would have given the same results, although the manager believes results of actual trades would have been very similar. Performance results reflect the re-investment of dividends and other earnings. The performance results are net transaction costs and operating expenses associated with the management of the Arrow Alternative Strategy. The performance of the Hypothetical Arrow Alternative Strategy was reduced by 252 bps annually.

Performance displayed represents past performance, which is no guarantee of future results. The information provided here is for informational purposes only, is not intended as investment advice and should not be construed as a recommendation with regard to investment decisions. Source for charts and graphs: Morningstar, Bloomberg, Deutsche Bank calculated by Arrow Investment Advisor, LLC. The index returns assumes re-investment of all dividends but do not reflect any management fees, transaction costs or expenses. The indices are unmanaged and are not available for direct investment. The Strategy benchmark comparison returns are comprised of three Credit Suisse / Tremont hedge Fund Indices: 33.3% Long Short equity, 33.3% Fixed Income Arbitrage and 33.3% Managed Futures indices. The Credit Suisse/ Tremont hedge Fund Indices are the asset-weighted benchmarks of hedge fund performance. It is not possible to invest in indexes which are unmanaged and do not incur fees and charges. The 60% equities and 40% bonds is comprised of S&P 500 and Lehman Aggregate Bond Index. The S&P Index is the Standard & Poor’s Composite Index of 500 stocks and is a widely recognized, unmanaged index of common stock prices. The Lehman Brothers U.S. Aggregate Bond Index is an unmanaged index composed of investment-grade securities from the Lehman Brothers Government/Credit Bond Index, Mortgage- Backed Securities Index, and Asset-Backed Securities Index.