Hedge Fund Beta

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Hedge Fund Beta
Tony Beaulac ASA, CFA
December 2, 2008
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Contents

• Hedge Fund Replication
• Appendix A Legal Disclosures

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Hedge Fund Replication
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Hedge Fund Landscape

• The hedge fund industry has grown rapidly over
  past decade
• Assets have grown to between 2-4 trillion
• There are 8000-10000 hedge funds/fund-of-funds
• Competition for return opportunities has
  intensified
• No obvious evidence that market opportunities
  have increased
• Institutional Investors are searching for alpha
  and diversification through hedge funds
• While some hedge fund strategies produce alpha,
  academic research has shown that a significant
  portion of hedge fund returns come from Betas
  (traditional, alternative, exotic)

Source HFM Week, December 5, 2007 and Hedge
Fund Intelligence from Hedge Fund Daily, April
17, 2008 Source Richard Wilson, Hedge Fund
Investing Basics, Hedge Fund Corp, December
2007 Source Source Fung, Hsieh, Naik
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Academic Hedge Fund Research
Hedge fund returns consist of lots of betas and
some alpha
Alpha
Betas
Non-linear, option-like Betas, and Exotic Betas
Alternative Betas
Traditional Betas

• How can investors replicate these exposures?

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Relative Performance of Hedge Fund StylesHFRITM
Non-Investable Indexes
Source HFRI Indices Annual Investment Returns
(1997 Q2 2007) Past performance is not a
guarantee of future results
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Explaining and Replicating Hedge Fund Strategies
Primitive Trading Strategies (PTS) and Academic
Research
Style Strategy
Trend Followers (Managed Futures) Lookback
Straddles (Fung, Hsieh 2001) Merger
Arbitrage Short put option (Mitchell, Pulvino
2001) Fixed Income Credit Spread (Fung, Hsieh
2002) Long/Short Equity Market, Size (Fung,
Hsieh 2006) Convertible Arbitrage Rule based
Convert port (Agarwal et al. 2005) Distressed
Securities CSFB high yield (Fung, Hsieh
2007) Equity Long-Biased Wilshire Growth (Fung,
Hsieh 2007)
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Example of Primitive Trading Strategy
Equity Long-Biased Funds PTS
Source Fung, William K.H. and Hsieh, David A,
"Hedge Funds An Industry in Its Adolescence,"
Economic Review, Federal Reserve Bank of
Atlanta, Fourth Quarter, 2006.
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Example of Primitive Trading Strategy
Trend Followers (Managed Futures) PTS using
Lookback Straddles
Source Fung, William K.H. and Hsieh, David A,
"Hedge Funds An Industry in Its Adolescence,"
Economic Review, Federal Reserve Bank of
Atlanta, Fourth Quarter, 2006.
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Example of Primitive Trading Strategy
Trend Followers (Managed Futures) PTS using
Lookback Straddles Contd
Source Fung, William K.H. and Hsieh, David A,
"Hedge Funds An Industry in Its Adolescence,"
Economic Review, Federal Reserve Bank of
Atlanta, Fourth Quarter, 2006. Past performance
is not a guarantee of future results.
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Hedge Fund Replication

• Academic research has shown that
• Hedge fund strategies can be replicated
• And that hedge fund of fund composites can be
  replicated

Bill Fung and Narayan Naik from the London
Busines School, and David Hsieh of Duke
University, have been leaders in this research
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Hedge Fund Replication The Process
STEP 1 Define the target Need to find those
funds that deliver the desired risk
profile   STEP 2 Select the right set of
liquid, investable factors based on Academic
Research/Regression Analysis Understand the
strategy risk-premia STEP 3 Construct a Hedge
Fund Beta portfolio Dynamic allocation of risk
capital to reflect current market conditions  
IDXP
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Step 1 Finding the Right Target
Step 1 Define the Target
Gather data from hedge fund return
sources/databases
Source Fung, Hsieh, Naik May 14, 2008
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Step 2 Regression Analysis of Hedge Fund
ReturnsConducted by Fung, Hsieh, Naik
Eight Factor Model Regressed on Hedge
Funds-of-Funds Index Returns (rolling 24 months)
Explains 80 of the return variance of the Hedge
Funds-of-Funds returns

• Traditional Beta
• Equity risk premium
• Emerging Markets
• Alternative Betas
• Term premium
• Credit premium
• Small stock premium (value)
• Exotic Beta
• Three lookback option straddles (fixed, currency
  and commodities)
• Picks up the non-linear return pattern

Return of a fund (weight of factor 1 return
of factor 1 ) (weight of factor n return of
factor n)
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Step 3 Construct a Hedge Fund Beta Portfolio
Portfolio Construction
Factor
Implementation
Equity Risk Premium
SP 500/Emerging Markets
Term Premium
10 Year Spread
Default Risk Premium
Credit Spread
Small Value Premium
Small Cap Large Cap
Dynamic Trading Strategies
Lookback Straddles

• Factor exposures are replicated using direct and
  synthetic instruments
• Hedge fund factor exposures may dictate the use
  of leverage and shorting in the strategy

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Hedge Fund Beta
Average Factor Weights
Average Factor Weights Jan 2003 Dec 2006
Small-Large US Stocks 7
Cash 56
Credit Spread 15
Term Premium 5
Emerging Markets 15
Lookback Straddles 2
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Hedge Fund Beta
Factor weights change slowly Factor weights
through time (January 2003 to December 2006)
See Page25 for Simulation Disclosure SSgA
Hedge Fund Beta Strategy this page cannot be
used without the accompanying footnotes.
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Simulated Hedge Fund Returns for a New Investor
HFR Composite 11.4 MSCI Inv 5.3 HFR Inv 4.8
HFB 6.6 (July 2003 to December 2007)
Simulated performance
See Page 25 for Simulation Disclosure SSgA
Hedge Fund Beta Strategy this page cannot be
used without the accompanying footnotes.
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SSgA Hedge Fund Beta Strategy
Annualized returns for period ending September
30, 2008 in US dollars Q3 08 YTD
1-Yr Since Inception SSgA Hedge Fund
Beta Strategy -2.42 -1.96
-1.75 1.21HFRI Fund of Funds Composite
Index -8.84 -11.05 -9.29 -8.07 HFRX Equal
Weighted Strategies Index -8.82 -9.32
-9.25 -8.91

Inception of SSgA Hedge Fund Beta Strategy
July 31, 2007 The performance shown is of a
composite created on 3/1/2008 consisting of all
discretionary accounts using this investment
strategy. There is no minimum account size
required for inclusion in the composite. New
funds or accounts are added to the composite upon
the first full month of operation and closed
funds or accounts are removed from the composite
upon the last full month of operation. A
complete description of this composite as well as
a complete presentation that complies with the
requirements of the GIPS standards is available
upon request. Historic performance is not
necessarily indicative of future performance,
which could differ substantially. The
performance figures contained herein are provided
on a gross of fees basis and do not reflect the
deduction of advisory or other fees which could
reduce the return. For example, if an annualized
gross return of 10 was achieved over a 5-year
period and a management fee of 1 per year was
charged and deducted annually, then the resulting
return would be reduced from 61 to 54. The
performance includes the reinvestment of
dividends and other corporate earnings and is
calculated in US dollars. The index returns are
unmanaged and do not reflect the deduction of any
fees or expenses. The index returns reflect all
items of income, gain and loss and the
reinvestment of dividends and other
income. Performance returns for periods of less
than one year are not annualized.
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Real World Applications
How can I use a synthetic hedge fund?

• Better asset class benchmark
• Measure the performance of your Fund of Fund
  Manager or overall hedge fund allocations
• Reasonable exposure to the asset class
• Free of manager-specific risk (no Long Term
  Capital or Bears Stearns)
• Easy to explain and replicate
• Transparent
• Liquid
• Low cost
• Core satellite approach
• Assure yourself of hedge fund like returns and
  seek alpha strategically/tactically
• Short-term exposure
• Use during transitioning between managers
• Liquidity vehicle within overall hedge fund
  allocation

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Appendix A Legal Disclosures
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Simulation Disclosure
SSgA Hedge Fund Beta Strategy

• Simulations were conducted to measure how a
  portfolio using alternative betas derived from
  factor analysis of hedge fund returns would
  perform versus hedge fund indexes over a 24 month
  time horizon. Returns were simulated from July,
  2003 to December, 2006 and assume 10 basis points
  in transaction costs. Turnover was limited to
  180 annually. The testing methodology used a
  proprietary model developed by William Fung,
  Narayan Naik and David Hsieh (the academics) to
  generate simulated historical portfolios. The
  hedge fund attribution factor and weighting
  analysis was backtested in March, 2007. All
  simulations were conducted by State Street Global
  Advisors. SSgA sought the most cost effective
  means of obtaining exposure to the factors
  identified in collaboration with our academic
  colleagues. Since the comparable indices
  performances were calculated net of fees, SSgA's
  simulated performance was calculated net of
  management fees (0.50 annually).
• The results shown do not represent the results of
  actual trading using client assets but were
  achieved by means of the retroactive application
  of a model that was designed with the benefit of
  hindsight. The simulated performance was compiled
  after the end of the period depicted and does not
  represent the actual investment decisions of the
  advisor. These results do not reflect the effect
  of material economic and market factors on
  decision-making.
• The simulated performance data is reported on a
  gross of fees basis, but net of administrative
  costs. Additional fees, such as the advisory fee,
  would reduce the return. For example, if an
  annualized gross return of 10 was achieved over
  a 5-year period and a management fee of 1 per
  year was charged and deducted annually, then the
  resulting return would be reduced from 61 to
  54. The performance includes the reinvestment of
  dividends and other corporate earnings and is
  calculated in US dollars.
• The MSCI Hedge Invest IndexSM is designed to be
  both investable and to reflect the overall
  structure and composition of the hedge fund
  universe. The composite-level MSCI Hedge Invest
  IndexSM includes funds from a wide range of hedge
  fund investment strategies available on a third
  party hedge fund platform. Eight new strategy
  level indices subdivide the MSCI Hedge Invest
  Index, contain funds with weekly liquidity and
  are designed to be licensed for use as a basis
  for tradable investment products.
• The simulated performance is not necessarily
  indicative of future performance, which could
  differ substantially. The benchmark returns are
  net of fees. The benchmark returns reflect all
  items of income, gain and loss, the reinvestment
  of dividends and other income, as well as
  management fees.
• Not all products will be available to all
  investors, please contact SSgA for further
  information regarding this strategy.
• The performance information should not be shown
  without these accompanying notes.

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Hedge Fund Research by Fung, Hsieh and Naik
William Fung (London Business School), David
Hsieh (Duke), Narayan Naik (London Business
School)
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Market Outlook Disclosure

• The views expressed (contained) in this material
  are the views of SSgA through the period ended
  September 30, 2008 and are subject to change
  based on market and other conditions. The
  information we provide does not constitute
  investment advice and should not be relied upon
  as such. It should not be considered a
  solicitation to buy or offer to sell a security.
  It does not take into account any investors
  particular investment objectives, strategies, tax
  status or investment horizon. We encourage you
  to consult your tax or financial advisor. All
  information has been obtained from sources
  believed to be reliable, but its accuracy is not
  guaranteed. There is no representation or
  warranty as to the current accuracy, reliability
  or completeness of, nor liability for, decisions
  based on such information. Past performance is
  not a guarantee of future results. SSgA may have
  or may seek investment management or other
  business relationships with companies discussed
  in this material or affiliates of those
  companies, such as their officers, directors and
  pension plans.

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Footnote Comparison of Hedge Fund Indexes
Sources
HFRX Equal Weighted Strategies Index is
constructed from the same strategies as the HFRX
Global Hedge Fund Index and every strategy is
given equal weight. As a result, it offers a more
balanced diversification and historically lower
volatility. The HFRX Global Hedge Fund Index is
designed to be representative of the overall
composition of the hedge fund universe. It is
comprised of eight strategies convertible
arbitrage, distressed securities, equity hedge,
equity market neutral, event driven, macro,
merger arbitrage, and relative value arbitrage.
The strategies are asset weighted based on the
distribution of assets in the hedge fund
industry. CSFB/Tremont Hedge Fund Index is
compiled by CSFB/Tremont Index LLC. It is an
asset-weighted hedge fund index that includes
only funds, as opposed to separate accounts. The
Index uses the CSFB/Tremont and TASS database,
which track over 4500 funds, and consists only of
funds with a minimum of US10 million under
management, a 12-month track record, and audited
financial statements. It is calculated and
rebalanced on a monthly basis, and shown net of
all performance fees and expenses. CSFB/Tremont
Investable Hedge Fund Index, comprised of 60
funds across 10 style-based sectors, is
constructed as a sub-set of the CSFB/Tremont
Hedge Fund Index, the most widely quoted hedge
fund index in the world. The Investable Index is
asset weighted and enables investors to gain
diversified exposures to the hedge fund industry.
It is the exclusive property of CSFB Tremont
Index LLC. HFRX Investable Hedge Fund Index is
designed to be representative of the overall
composition of the hedge fund universe. It is
compromised of eight strategies which are asset
weighted based on the distribution of assets in
the hedge fund industry. It is the exclusive
property of Hedge Fund Research. The MSCI Hedge
Invest IndexSM is designed to be both investable
and to reflect the overall structure and
composition of the hedge fund universe. The
composite-level MSCI Hedge Invest IndexSM
includes funds from a wide range of hedge fund
investment strategies available on a third party
hedge fund platform. Eight new strategy level
indices subdivide the MSCI Hedge Invest Index,
contain funds with weekly liquidity and are
designed to be licensed for use as a basis for
tradable investment products.
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Hedge Fund Beta Disclosure
The Hedge Fund Beta Strategy is a model driven
strategy based on regression analysis designed to
capture the beta exposure as inherent in hedge
fund investments. Since the betas include
factors such as the equity risk premium, credit
spreads, the term premium and the small cap
premium, this strategy includes risks associated
with all these asset classes and other common
risks associated with investing in general,
including hedge fund investments.
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Thank You