Alternative Beta Strategies: a New Paradigm to the Hedge Fund Industry

Hedge Fund Return Sources

Alternative Beta Strategies: A new paradigm to the hedge fund industry

Dr. Lars Jaeger, Partner Partners Group

Table of contents 2

I Alpha versus Beta in hedge fund returns

II Implications: Why hedge fund replication is interesting

III The two essential approaches

IV Core – Satellite portfolios: A new paradigm to hedge fund investing

Alpha versus beta in hedge fund returns

The hedge fund return puzzle

There is a widely held belief that hedge funds earn their returns through the identification of market “inefficiencies” and by superior investment selection, i.e. by producing “alpha”.

However … since hedge funds generally trade in the most efficient markets:

Is it really plausible that remaining inefficiencies in these markets can provide a steady stream of alpha to the USD 1,500+ billion hedge fund industry?

Are hedge fund managers really so much smarter than traditional managers?

ThereThere mustmust bebe another,another, hiddenhidden sourcesource ofof returnsreturns drivingdriving aa significantsignificant partpart ofof thethe performancperformancee ofof manymany hedgehedge fundfund strategiesstrategies

1 Alpha versus beta in hedge fund returns

Discovering the “atomic structure” of hedge fund returns 4

The model of an atom in 1895 The model of an atom according to modern quantum physics

β β α α ε α

α α β1 α α β2 β α ε β3 β ε β 4 α α β5 β α α 7 α ε β6 ε α α α The model of returns in a hedge The emerging model of hedge fund portfolio until today fund return sources

Alpha versus beta in hedge fund returns

Understanding Hedge Fund Returns:

A Simple Model 5

Traditional mutual fund Hedge fund

Superior: “Alpha” - Security selection α -Market Timing

Currency Risk Premium

Event Risk Premium

Convergence Risk Premium Commodity Risk Premium Alt-

Complexity Risk Premium β Market risk Proclaimed Short Vega Risk Premium Hedge Leverage premium alpha Liquidity Risk Premium Term Curve Risk Premium

Small Cap Risk Premium β Value Stocks Risk Premium

Leveraged proclaimed alpha Credit Risk Premium

EmMa Risk Premium

Equity Risk Premium Market- One of many investors’ most frequent mistakes is not looking deeper into a hedge fund’s proclaimed alpha.

Alpha versus beta in hedge fund returns

Traditional Beta vs. Hedge Fund Beta (Alternative Beta) 6

Traditional Beta Hedge Fund Beta (Alternative Beta)

Exposure to: Exposure to: Broad equity market Style factors, such as small cap vs. Interest rates (duration) large cap, value vs. growth, momentum (Long/Short Equity, Equity Market Credit risk Neutral) Emerging markets Event risk (Merger Arbitrage) Volatility (Convertible Arbitrage, Volatility Arbitrage) Risks of commercial hedgers in futures markets (Managed Futures) Liquidity risk (Distressed Securities, Fixed Income Arbitrage, Reg D) Spread risk, e.g. carry trades (Global Macro)

Exposure to Hedge Fund Beta requires special investment techniques including short selling, leverage, and the use of derivatives. Thus, hedge funds have exclusive access to these Alternative Betas.

2 Alpha versus beta in hedge fund returns Some words of caution : Distinguish between alpha and beta 7

Distinguish „alphas” and „betas” in hedge funds

Alpha and beta do not come separately. Often hedge funds come with “phantom alphas” (i.e. beta is sold as alpha) Phantom alphas are not persistent Phantom alphas can even be related to unwanted and uncontrolled systematic risks Unwanted and uncontrolled systematic risks often lead to DI-WORSE-IFICATION

History and common sense tells us:

The real risk from hedge funds comes from: unwanted and unknown leveraged systematic risk uncontrolled manager related risk (style drifts, faulty operations, fraud, etc.)

Table of contents 8

I Alpha versus Beta in hedge fund returns

II Implications: Why hedge fund replication is interesting

III The two essential approaches

IV Core – Satellite portfolios: A new paradigm to hedge fund investing

Why hedge fund replication is interesting

Hedge Fund Alpha Is Diminishing … 9

The development of alpha (excess return over a rolling linear factor regression) over a 60 month time window for various strategies : 1.0% Equity Hedge Event Driven Merger Arbitrage Convertible Arbitrage 0.8%

0.6%

0.4%

0.2%

Monthly alphain percent 0.0%

5 5 02 02 04 04 07 07 l 01 t 01 02 t l 03 04 t l 05 06 r 06 l 06 u k an k u u an u pr Jan 01Apr 01 J O J Apr 02 Jul O Jan 03Apr 03 J Okt 03Jan Apr 04 Jul Ok Jan 0 Apr 0 J Okt 05J Ap J Okt 06Jan A Jul 07Okt 07

-0.2%

HFRI Index Replicating Factors EH S&P 500 Russell 2000 BXM Buywrite Index AR(1) AR (1) = Autoregressive factor for tracking of stale pricing ED S&P 500 Russell 2000 CS High Yield Index AR(1) MERFX = Merger fund index MA SMB Russell 3000 MERFX BXM Buywrite Index AR(1) SMB = Small minus Big (Small Cap Factor) Citigroup CA S&P 500 CS High Yield Index AR(1) Convertible Index

Data source: HFR, Bloomberg. Calculation: Partners Group

3 Hedge fund return sources

Hedge fund returns:

Yesterday, today and tomorrow 10

Average Hedge Fund Return Components over Time

14%

12%

10% α (15%) (48%) α 8%

Expected return (42%) (35%) (60%) 4% Alt-β α Alt-β

2% Alt-β (35%) M-β (25%) M-β (10%) M-β (30%) 0% 2008-2012 1995-1999 2000 - 2007

βeta = is a risk premia and a compensation for a risk taken

αlpha = is the result of a zero-sum game (one’s profit is another’s loss)

Why hedge fund replication is interesting

Hedge funds in a global portfolio 11

The traditional “Balanced Portfolio” does not include other risk premia that have favorable diversification qualities and generate attractive alternative returns.

Commodity Roll Yield risk hedging risk Equity risk Volatility risk Convergence risk Complexity /efficiency risk Momentum risk Traditional investors benefit only from a few risk premia (blue) Value risk available in the market and miss multiple other sources of return! Event risk

FX Carry risk Term risk Duration (Bond) Credit risk risk Convergence risk EmMa risk

Investors can access other uncorrelated alternative “risk premia” and thus return sources through hedge funds.

TheThe realreal benefitsbenefits fromfrom hedgehedge fundsfunds dodo notnot necessarilynecessarily comecome fromfrom accessingaccessing today’stoday’s starstar trader,trader, butbut fromfrom thethe persistepersistentnt benefitsbenefits ofof alternativealternative riskrisk premiapremia

Why hedge fund replication is interesting

The Issue of Hedge Fund Fees 12

Pay a lot (and even more in the future) for true alpha skill unavailable anywhere else

Pay less for systematic exposure to alternative betas, but more than regular stock market beta as extra skills are required

Don‘t pay hedge fund fees for Hedge fund fees traditional beta exposure (even when a few short positions are thrown in for credibility)

Hedge fund fee structure does not discriminate between skill based performance (alpha) and risk factor compensation (beta)

4 Why hedge fund replication is interesting

Fees I: How about saving the manager fee

layer? 13

FoF PG ABS Hedge Fund Return Gross of Fees 9% - 18% 9% - 18% Management Fee HF (2%) / PG ABS (1.25%) 2.0% 1.25% Performance Fee HF (20%) / PG ABS (15%) 1.4% – 3.2% 1.2% - 2.5%

Hedge Fund Return Net of Fees 5.6% - 12.8% 6.6% - 14.2% Management Fee FoF (1%) 1.0% Performance Fee FoF (10% above US LIBOR) 0.2% - 0.9% FoF Return Net of Fees 4.4% - 10.9% 6.6% - 14.2%

Share of Return Payed Off to Investor 90% 80% 70% 60% 50% 40% 30% FoF 20% PG ABS 10% 0%

% % % % % 4 6 8 0% 4 8 1 12% 1 16% 1 20% 22% 24% 26% 28% 30% Gross of Fees Return

Total fee savings potential: 220 bps – 330 bps p.a.

Why hedge fund replication is interesting

Fees II: Do you really need to pay asymmetric

performance fee in fund of funds? 14

The ABS performance fee is only paid on the netted performance. In contrast, for a portfolio of hedge funds the performance is not netted.

Gross Gross Net Performance ABS: Performance Performance combined: After 15% Hedge Fund 1 Hedge Fund After 20% performance performance 2 fees fees

+12% +9.6% +5.1% = +3.6%

-6% -6%

Total fee savings potential: 40 bps – 80 bps p.a.

Why hedge fund replication is interesting

Fees III: How can you avoid to pay prime

brokers excess leverage financing fees 15

ABS typically employ instruments like futures and options that allow exposure to the desired market with only a fractional size of the underlying cash. Therefore cash can be employed several times.

Leverage without external borrowing Hedge Fund B ABS pays Libor +45 bps for leverage External borrowing

Hedge Fund A excess cash Traditional receives Libor Fund of -35 bps for funds: required collateral excess cash No access to excess cash Average Exposure of Fund of funds Exposure

…

HF A HF B HF n

Total fee savings potential: 40 bps – 80 bps p.a.

5 Table of contents 16

I Alpha versus Beta in hedge fund returns

II Implications: Why hedge fund replication is interesting

III The two essential approaches

IV Core – Satellite portfolios: A new paradigm to hedge fund investing

The two essential approaches

Modeling Alternative Beta:

Two Different Approaches 17

A. Top down: Linear Regression Approach (RFS)

Identify Factors Invest Replication through Direct exposure generic (linear) risk to explaining exposure (Replicating factors Factor Strategies - RFS)

B. Bottom up: Non-linear rule-based Approach (AltBeta Strategies)

Identify Well known Invest Risk Premia ideas With rule-based Identify various Hedge Identified Risk Premia approach like Fund Risk Premia by backed by academic Hedge Funds do analyzing the industry research

The two essential approaches

1. The Top Down Approach - Linear regressions

Hedge Fund

Superior: -Security selection We compare the performance of the factor model -Market Timing α to the performance of the hedge fund strategy indices (HFRI, HFRX, S&P, where available). Currency Risk Premium

Event Risk Premium

Convergence Risk Premium Commodity Risk Premium

Complexity Risk Premium Re = α + Σ (βi* Fi) Short Vega Risk Premium Liquidity Risk Premium β Small Cap Risk Premium The “replicating factor strategy”(in the Value Stocks Risk Premium following referred to as “RFS”) returns are simply Term Curve Risk Premium calculated based on the factor returns times the Credit Risk Premium factor weights. The latter were obtained based on a rolling regression analysis of a five year EmMa Risk Premium window, i.e. no in-sample optimization. Equity Risk Premium

6 The two essential approaches

Replicating Factor Strategies applied 19

Results of the regression using the HFR event driven index as a dependent variable: Factor Beta/Alpha t-stat Adj. R-squared S&P 500 21.3% 9.84 82.6% Russell Spread (Small - Large) 20.0% 9.36 CS High Yield 27.0% 5.52 AR (1) 20.7% 4.83 Constant (=Alpha) 0.4% 4.62 Comparison of the replicated strategy (factors above) with the HFR event driven 5% RFS correlation: 93% 4% RFS

-1% Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 -2%

-3% Data: HFR, Bloomberg. Calculation: Partners Group -4%

-5%

Wouldn‘t it be great if we could separateGood news: the return components and compensate them specificallyFairly simple and toaccordingly? calculate and invest!

The two essential approaches

Trading RFS: Two Examples 20

Good replication Less good replication Long/Short Equity Distressed 150 145 RFS HFRX DS RFS HFRX EH 145 140 140 135

130 135

125 130

120 125

115 120

110 115

105 110

100 105

95 100 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jan-04 Apr-04 Jan-05 Apr-05 Jan-06 Apr-06 Jan-07 Apr-07 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07

RFS does not work as well RFS works

Reference: L. Jaeger et al., “Modeling and Benchmarking of Hedge Funds: Can passive hedge fund strategies deliver?”, Journal of Alternative Investment, Winter 2005

The two essential approaches

Why Do RFS Not Always Work? 21

Limitations of RFS

1. No nonlinearity 2. Backward looking 3. Mostly equity exposure

RFS 1600 S&P 500 1500 HF return 1400

1300

1200

1100

1000

return of hedge fund strategy return 900

800 return of systematic risk factor (size of risk premium) 700 8.28.99 8.27.00 8.27.01 8.27.02 8.27.03 8.26.04 8.26.05 8.26.06 8.26.07

¾ RFS are linear ¾ RFS is backward looking: In ¾ RFS models and approximations of hedge contrast to hedge fund managers incorporates mostly the fund returns. They do not who base their decisions on equity exposure of consider non-linear payout current data, RFS adjusts hedge funds, i.e. profiles inherent in hedge exposures with a significant time specifically that part that fund strategies! lag. This can be problematic in a is least attractive to fast changing environment! investors. Bad news: RFS is Wouldn‘tnot suitable it be to great describe if we hedge could fund separate returns the in return all market components environments. and It mostly compensatecaptures the them part specificallyof hedge fund and returns accordingly? that investors find least attractive

7 The two essential approaches

B. Bottom up rule-based approach:

the PG AltBeta model 22

Observable hedge fund Supporting academic Hedge fund investment strategies + research + techniques

Hedge Funds

Managed Futures EquityEquity HedgedHedged RelativeRelative ValueValue Event-DrivenEvent-Driven OpportunisticOpportunistic (CTA)(CTA)

Long/Long/Short Short ConvertibleConvertible RiskRi sk Arbitrage Ar bit ra ge GlobalGlobal AssetAsset AllocatorAllocator SystematicSystematic -- Technical Technical EquitiesEquities ArbitrageArbitrage (Merger(Merger && Acquisition) Acquisition) (Global(Global Macro)Macro) (Trend(Trend Follower)Follower)

EquityEquity MarketMarket FixedFixed IncomeIncome SpecialSpecial SituationsSituations SystematicSystematic -- Technical Technical Carry Strategies TimerTimer ArbitrageArbitrage (Spin-off,(Spin-off, etc.)etc.) Carry Strategies (Counter(Counter Trend)Trend)

Distressed Securities/ Short Sellers Derivative Arbitrage Distressed Securities/ DiscretionaryDiscretionary -- Active Active Short Sellers Derivative Arbitrage High Yield High Yield (Fundame(Fundamental/Spread) nt al /S prea d)

EquityEquity MarketMarket Neutral RegulationRegulation DD (Statistical(Statistical Arbitrage)Arbitrage) (Convertible(Convertible Debenture) Debenture)

Alternative Beta Strategies (AltBeta)

Wouldn‘tPG AltBeta it be marries great ifin-depth we could industry separate experience, the return academic components risk and premia compensate themresearch specifically and hedge and fundaccordingly? investment technique

G:\Products\Hedge Funds\PG Alternative Beta Strategies\Presentations\2008\04 2008 – Partners Group Alternative Beta Strategies

The two essential approaches

2. The risk premium based approach – Bottom up 23

¾ Instead of replicating of hedge fund indices gain direct exposure to individual hedge fund risk premia, i.e. alternative betas

¾ Various risk premia in the global capital markets (alternative Betas) are the “atoms” of hedge fund returns. Note: Returns in single hedge fund strategy sectors are often already a composition of various risk premia

¾ Modeling and investing in hedge fund risk premiums (i.e. alternative betas) requires alternative investment techniques (see before). Simple asset class exposures cannot do the job of extracting alternative betas.

¾ Therefore, extracting alternative betas requires the definition and implementation of rule based trading strategies. We refer to these as “Alternative Beta Strategies”. Examples include trend following, spread trading and option strategies

¾ The definition and extraction of alternative beta strategies is not a pure job of mathematical optimization. It also requires sound understanding of hedge funds themselves. Note: A fund of funds perspective can be extremely helpful here.

The two essential approaches

Bottom up - Rule-based Approach: Example I 24

Earning the “commodity hedging demand premium”: Involves taking the opposite position of commercial hedgers transferring their natural price risks.

450 SGFII * volatility adjusted for the SGFII volatility Return: 11.8% p.a. 400 CISDM Systematic* Volatility: 11.5% p.a.

350 Return: 10.0% p.a. Volatility: 11.5% p.a.

300

250

200

150

100 06.94 06.95 06.96 06.97 06.98 06.99 06.00 06.01 06.02 06.03 06.04 06.05 06.06 06.07

Rule-based strategy: Trend following on 25 most liquid US futures markets. Positive momentum leads to long positio negative momentum leads to short position.

Source: Bloomberg (SGFII , CISDM) See also L. Jaeger et al in “The sGFI – A case study”, Journal of Alternative Investments, Summer 2002.

8 The two essential approaches

Bottom up - Rule-based Approach: Example II 25

Involves selling down-side protection to equity investors 150 Return: 5.0% p.a. BXM Index Volatility: 9.8% p.a. 140 Tremont Long/Short Index Return: 4.5% p.a. 130 Volatility: 9.2% p.a.

120

110

100

70 12.99 12.00 12.01 12.02 12.03 12.04 12.05 12.06 12.07 Rule-based strategy: Involves buying stocks and selling simultaneously (covered) call options.

Source: Bloomberg

The two essential approaches

Bottom up - Rule-based Approach: Example III 26

Performance of the Deutsche Bank Carry Index Excess Return (over risk free): 2.7% p.a. Volatility: 6.3% p.a. 140 135 130 125 120 115 110 105 100 95

Rule-based strategy: Borrow from low yielding currencies, invest in high yielding currencies

Source: Bloomberg

The two essential approaches

Integration of alternative risk premia: a simple example 27

How alternative risk premium play together – a simple example Combination of trend following (SGFII), “buy-write” (BXM), and credit strategy (CSFB HY index), equally weighted Performance 500 Annualized Return: 9.7% p.a. 450 Annualized 400 Volatility: 5.4%

350 p.a.

300 Maximum Drawdown: -9.8% 250 Performance 200 Annualized 150 Return: 7.7% p.a. 100 Annualized 50 Volatility: 5.7% p.a.

01.12.93 01.12.94 01.12.95 01.12.96 01.12.97 01.12.98 01.12.99 01.12.00 01.12.01 01.12.02 01.12.03 01.12.04 01.12.05 01.12.06 01.12.07 Maximum S&P500TR HFR Composite HFR FoF Trilo gy Drawdown: -13.1% Source: Bloomberg, CBOT

9 The two essential approaches

History of Alternative Beta Strategies 28

1997: Publication of “Empirical Characteristics of Dynamic Trading Strategies: The case of hedge Funds” by Fung Hsieh 2003: Introduction of the term “alternative beta” by Fung et al. in “The Risk in Hedge Fund Strategies: Alternative Alphas and Alternative Betas”, in L. Jaeger (ed): “The new generation of Risk management for Private Equity and HF Investments”. Partners Group (PG) research published; “Hedge Fund Return sources” topic on annual PG round tables Decision to launch replicating beta hedge fund strategies; Launch of ABS quant team 2004: Extensive research at PG of making risk premia models investable October: Inception of PGAS Green Vega Cell; starting point of ABS track record 2005: End of 2005: First institutional interest in hedge fund replication 2006: Tremendous institutional interest in hedge fund replication November: FT article triggers wave of discussion of hedge fund replication in the global financial industry Asset base of PG ABS program up to 580 Mio. USD Partners Group launches its first core-satellite products 2007: Asset base of PG ABS program exceeds 800 Mio. USD Strategy set expanded to 40 strategies 2008: Launch of “passive” fund of alternative betas

The two essential approaches

Alternative Beta: The real benefits of hedge funds 29

¾ Dilemma for many hedge fund replicators: There is a lot of equity beta in current hedge fund returns. But: Clients want absolute and uncorrelated returns.

¾ The large pack of currently available hedge fund replicators has chosen to follow a very simple path: Why not giving up on alternative beta and model hedge funds with traditional beta only?

¾ This actually proved reasonably successful in the last four years (which is exactly the period most providers chose to display when they show their back-tested performance to attract investors) but would have failed miserably in the bear market from March 2000 to March 2003 - a period when hedge funds as an aggregate made money despite heavy losses in the equity markets.

¾ More sophisticated investors would probably agree that this is not an acceptable concept to generate hedge fund exposure as it does not provide what investors want from hedge funds.

¾ Alternative beta (risk premia beyond traditional equity (and bond) beta) can serve as a great diversifier and is ultimately the strongest rational to invest in hedge funds.

The two essential approaches

Alternative Beta kept up with equity beta in

the bull market 2003-2007 30

Performance of a risk weighted average of simplified alternative beta returns compared to the Merrill Lynch factor model as a good proxy for the “equity component” in hedge fund return.

YTD 2003-2007

112 168

Average Alternative Beta* ML Factor Index 110 158 ML Factor Index Average Alternative Beta* 108 148

106 138

104 128

102 118

100 108

98 98 03.04.2003 03.06.2003 03.08.2003 03.10.2003 03.12.2003 03.02.2004 03.04.2004 03.06.2004 03.08.2004 03.10.2004 03.12.2004 03.02.2005 03.04.2005 03.06.2005 03.08.2005 03.10.2005 03.12.2005 03.02.2006 03.04.2006 03.06.2006 03.08.2006 03.10.2006 03.12.2006 03.02.2007 03.04.2007 03.06.2007 03.08.2007 03.10.2007 03.12.2007 29.12.2006 28.01.2007 27.02.2007 29.03.2007 28.04.2007 28.05.2007 27.06.2007 27.07.2007 26.08.2007 25.09.2007 25.10.2007 24.11.2007 24.12.2007

Alternative Beta factors: Deutsche Bank Carry Index, CDX High Yield Index, CRB Commodity Index, Value versus Growth Spread, Small cap versus large cap spread, BXM covered call writing (BXM Index- 0.5*SPX Index), the Merger Arbitrage Fund (MERFX Index), and the spread between emerging market equity returns and developed equity markets (MSCI Emerging Markets – MSCI World) Source for ML factor model: Bloomberg, PG calculation prior to 2003

10 The two essential approaches

The real benefits of Alternative Beta over

the full investment cycle 31

190 ML Factors Average Alternative Beta* 180

170

160

150

140

130

120

110

100

90 31.12.99 29.02.00 30.04.00 30.06.00 31.08.00 31.10.00 31.12.00 28.02.01 30.04.01 30.06.01 31.08.01 31.10.01 31.12.01 28.02.02 30.04.02 30.06.02 31.08.02 31.10.02 31.12.02 28.02.03 30.04.03 30.06.03 31.08.03 31.10.03 31.12.03 29.02.04 30.04.04 30.06.04 31.08.04 31.10.04 31.12.04 28.02.05 30.04.05 30.06.05 31.08.05 31.10.05 31.12.05 28.02.06 30.04.06 30.06.06 31.08.06 31.10.06 31.12.06 28.02.07 30.04.07 30.06.07 31.08.07 31.10.07 31.12.07

The two essential approaches

Alternative beta correlation are far more beneficial 32

Rolling correlation (60 days) of the risk weighted average of alternative beta returns to the MSCI World Equity Index are much lower than the 90-100% correlation regression based models display.

0.8

Average Correlation of Alternative Beta Factors to MSCI World ML Factors 0.6

0.4

0.2

-0.2 10.04.03 10.06.03 10.08.03 10.10.03 10.12.03 10.02.04 10.04.04 10.06.04 10.08.04 10.10.04 10.12.04 10.02.05 10.04.05 10.06.05 10.08.05 10.10.05 10.12.05 10.02.06 10.04.06 10.06.06 10.08.06 10.10.06 10.12.06 10.02.07 10.04.07 10.06.07 10.08.07 10.10.07 10.12.07

-0.4

The two essential approaches

Two portfolios of alternative betas:

Performance target parameters 33

AltBeta - Green Vega (goal: approximate global hedge fund industry)

Fee schedule: 1.25% management fee, 15% performance fee Net performance Target: Libor plus 400-600, Volatility Target: 6-8% Long term sensitivity to equity markets: Beta of 0.5

AltBeta - Black Vega (passive allocation: equally balanced across alternative risk premia)

Fee schedule: 1.25% management fee flat Net performance Target Libor plus 200-400 Volatility Target: 4-6% Long term sensitivity to equity markets: Beta of 0.2

11 The two essential approaches

Two portfolios of alternative betas: Asset

Allocation 34

Green Vega (active HF industry proxy) Black Vega (equally weighted risk budgets)

Deep Value Deep Value Long/Short I Long/Short I Min Var Long/Short II

Long/Short III GTAA Min Var

Carry Event Driven

CTA Long/Short II GTAA Volatility Fixed Income Arbitrage Arbitrage I ILS Carry Long/Short III CTA Fixed Income Merger Event Driven Arbitrage I Volatility Merger Arbitrage Fixed Income Fixed Income ILS Arbitrage Arbitrage Arbitrage I Arbitrage I

The two essential approaches

Two portfolios of alternative betas: Net

performance 35

150

145

140

135

130

125

120

115

110

105

100

95 Apr 08 Apr Apr 07 Apr Jun 07 Apr 06 Apr Jun 06 Apr 05 Apr Jun 05 Apr 04 Apr Jun 04 Okt 07 Okt 08 Feb Okt 06 Okt 07 Feb Okt 05 Okt 06 Feb Okt 04 Okt 05 Feb Feb 04 Feb Aug 07 Aug 06 Aug 05 Aug 04 Dez 07 Dez Dez 06 Dez Dez 05 Dez Dez 04 Dez

HFR Composite HFR FoF Black Vega (risk equally-weighted) Green Vega (active HF Industry tracker)

Table of contents 36

I Alpha versus Beta in hedge fund returns

II Implications: Why hedge fund replication is interesting

III The two essential approaches

IV Core – Satellite portfolios: A new paradigm to hedge fund investing

12 Core - Satellite Approach

The Core - Satellite

Investment Approach 37

Limitations of the replicating approach

Some hedge fund strategies (such as Distressed Securities, Activist Event Driven) do not lend themselves as much to successful replication because they rely, by their very nature, more on skill/know-how or special market access rather than systematic exposure (e.g. variable bias, highly opportunistic or highly selective).

There are managers in any strategy that have demonstrated an ability to generate alpha over time also after taking into account the systematic risk exposure biases of their strategy.

Such hedge fund strategies can offer significant diversification benefits to ABS, thereby improving the overall risk/return properties of a combined portfolio.

Core-satellite approach

So what does that mean for multi-

strategy multi-manager portfolios? 38

Similar to the long only investment industry, employ a Core–Satellite approach for hedge fund investing!

The model of returns in a hedge The emerging model of hedge fund portfolio until yesterday fund return sources

Superior: - Security selection α -Market Timing β α β β α ε

α β Currency Risk Premium β1 α Event Risk Premium β Convergence Risk Premium α β2 Commodity Risk Premium β β ε Complexity Risk Premium Alt-β β Short Vega Risk Premium 3 Liquidity Risk Premium β β4 ε Term Curve Risk Premium α β α β5 Small Cap Risk Premium β Value Stocks Risk Premium α β 7 Credit Risk Premium Market-β β EmMa Risk Premium ε β6 α Equity Risk Premium ε α α α α

Separate inexpensive Alternative Beta and skill-based Hedge Funds

Core - Satellite Approach

Complement PG ABS with

Alpha Producing Managers 39

Range of Alpha 1%- Expected alpha generated 5% by selected HF managers Outperformance of ABS due to 2%- a) lower fees 4% b) favorable cross-financing (notional)

Average Performance of hedge 4%- fund industry as represented 8% e.g. by average FoFs or “investable” hedge fund index Expected return of core / satellite program satellite return / of core Expected

A core/satellite approach combines the generic exposure to hedge fund returns with significant alpha returns by satellite managers

13 Summary

Summary and Conclusion 40

1. Hedge funds generate returns primarily through risk premia, and in addition also by exploiting inefficiencies in imperfect markets.

2. The concept of Alternative Beta Strategies goes further than factor based replication techniques in that it explicitly accounts for the non-linear dependency structure of hedge fund returns. It thus offers a valid, theoretically more sound, and cheaper alternative to the currently offered hedge fund index products.

3. Alternative Beta Strategies are based on a proven theoretical framework and have a proven track record more than three years.

4. Alpha and Beta do not come separate but in an uncontrolled and perhaps undesired (and cost-inefficient) combination. As in traditional investing a “core - satellite“ approach solves this. 5. A core - satellite approach to hedge fund investing emerges naturally: cost efficient exposure to hedge fund (“alternative”) Betas with ABS as the core. select Alpha generating managers as satellites.

Contacts 41

Dr. Lars Jaeger

Partners Group Zugerstrasse 57 6341 Baar-Zug Switzerland T: +41 41 768 85 02 F: +41 41 768 85 58

ZUG SAN FRANCISCO NEW YORK LONDON GUERNSEY LUXEMBOURG SINGAPORE BEIJING TOKYO SYDNEY

This material has been prepared solely for purposes of illustration and discussion. Under no circumstances should the information contained herein be used or considered as an offer to sell, or solicitation of an offer to buy any security. The information contained herein is confidential and may not be reproduced or circulated in whole or in part. The information is in summary form for convenience of presentation, it is not complete and it should not be relied upon as such. All information, including performance information, has been prepared in good faith; however Partners Group makes no representation or warranty express or implied, as to the accuracy or completeness of the information, and nothing herein shall be relied upon as a promise or representation as to past or future performance. This material may include information that is based, in part or in full, on hypothetical assumptions, models and/or other analysis of Partners Group (which may not necessarily be described herein), no representation or warranty is made as to the reasonableness of any such assumptions, models or analysis. The information set forth herein was gathered from various sources which Partners Group believes, but does not guarantee, to be reliable. Unless stated otherwise, any opinions expressed herein are current as of the date hereof and are subject to change at any time.

Disclaimer 42

This material has been prepared solely for purposes of illustration and discussion. Under no circumstances should the information contained herein be used or considered as an offer to sell, or solicitation of an offer to buy any security. Any security offering is subject to certain investor eligibility criteria as detailed in the applicable offering documents. The information contained herein is confidential and may not be reproduced or circulated in whole or in part. The information is in summary form for convenience of presentation, it is not complete and it should not be relied upon as such. All information, including performance information, has been prepared in good faith; however Partners Group makes no representation or warranty express or implied, as to the accuracy or completeness of the information, and nothing herein shall be relied upon as a promise or representation as to past or future performance. This material may include information that is based, in part or in full, on hypothetical assumptions, models and/or other analysis of Partners Group (which may not necessarily be described herein), no representation or warranty is made as to the reasonableness of any such assumptions, models or analysis. The information set forth herein was gathered from various sources which Partners Group believes, but does not guarantee, to be reliable. Unless stated otherwise, any opinions expressed herein are current as of the date hereof and are subject to change at any time.