Who is the investment manager

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An Introduction to Hedge Funds
2005 Simon Hopkins, Managing Director Richard
Tarvin, Director of Research
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Group Investment Committee
Investment Advisory
Investment Management
Multi-Manager Fund Products
Fund Research
Emerging Manager Program
Fortune Multi-Manager Advisory
Structured Products
Client Multi-Manager Advisory
Regulated by FSA

• Established in 1996 as leading hedge fund
  research and advisory firm

Registered with the SEC
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Variety of skill based strategies FoFs 1990 gt
Global Macro Giants 1970-80s (e.g. Soros)
Alfred Winslow Jones Long/Short Equities 1949
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No. of Hedge Funds 7,900
Source Hedge Fund Research
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Hedge Fund Assets gt1 trillion
Source Hedge Fund Research
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Source Hedge Fund Research
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Source Hedge Fund Research
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• Commitments from institutional investors and
  pension funds to grow by 40 over next few years.
  (Oliver, Wyman Co, UBS Warburg 2003)
• Global hedge fund assets up from 300bn in 2000
  to 780bn, representing 1.5 of global assets
  (source Morgan Stanley, 2004)
• Compound growth rate is 37 a year (source
  Morgan Stanley, 2004)
• Recent acceleration to 65 growth in 1st half
  2004 means annualised compound growth is now 50
  since 2000. (source FT Investment Adviser,
  October 2004)

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• Aim to reduce exposure to market volatility
• common in traditional investment styles
• Aim to preserve capital
• Seek to exploit market inefficiencies
• Typically arbitrage, but also include CTAs, long
  short equity, and high yield/
  distressed
• Target returns incremental to cash and bonds
• with lower volatility than bond or equities

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• Hedge Funds are highly risky
• Hedge Funds are only for sophisticated investors
• Hedge Funds are unregulated
• Hedge Funds invariably blow up

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• Hedge Funds aim to reduce risk and deliver
  consistent positive returns
• Minimums are falling
• Hedge Funds often regulated
• A few blow ups are inevitable - can be avoided!
• What about equity blow ups? Marconi, Enron,
  Worldcom. GM?

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• Structured products MAN Group
• Investible indices FTSE, SP, HFR, MSCI
• Single strategy funds
• Single strategy funds of funds
• Broadly diversified funds of funds i.e. Market
  Wizards Funds

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• Indices by definition made up of less
  attractive managers so
• lower returns. (lower fees, capacity
  commitments).
• The industry is not suited to indices owing to
  the
• asymmetrical nature of returns and the
  absolute return
• objective. The mean should not be the
  objective but the
• best of breed.
• Volumes prevent active management of underlying
  portfolio.

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• Cap guaranteed funds deliver unstable,
• indiscriminate assets posing a real threat
  to the
• stability of the underlying hedge funds.
  (FT 2004)
• Size precludes diversification (see MAN)
• Fees are typically egregious and returns may
• disappoint. (FSA 2003)

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• Undertake due diligence of principals and the
  team.
• Look for principals with genuine market
  experience
• Check the extent of the fund of funds managers
• own due diligence
• Ensure portfolio is diversified across managers
  and strategies
• TREDD carefully

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• Transparency - Understand the strategies
• you are investing in

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Look carefully to see who is pulling the strings
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It is not always what meets the eye
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• Transparency - Understand the strategies you are
• investing in
• Risk Management target returns relative to
  risks you are prepared to take

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Identifying a discernable edge is essential
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• Transparency - Understand the strategies you are
  
• investing in
• Risk Management target returns relative to
  risks
• you are prepared to take
• Experience - invest with seasoned professionals

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• Transparency - Understand the strategies you are
• investing in
• Risk Management target returns relative to
• risks you are prepared to take
• Experience - invest with seasoned professionals
• Diversification dont put all your eggs in
  one
• basket

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Hedge your bets.
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• Transparency - Understand the strategies you are
• investing in
• Risk Management target returns relative to
  risks you are prepared to take
• Experience - invest with seasoned professionals
• Diversification dont put all your eggs in one
  basket
• Discipline dont get drawn in by fad and
  fashions

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Invest for the right reasons e.g. skill not
size
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Opportunities in Hedge Fund Investing

• Misconceptions about opportunities
• Growth of hedge fund industry
• Relationship between performance asset growth
• Dynamics of opportunities within sub-strategies
• Current new opportunities in hedge fund industry

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Misconceptions About Opportunities

• Alternative Investment Opportunities Fail to
  Keep Pace with Asset flows"
• Wall Street Journal, 1998
• Hedge Funds no Longer able to Compete on
  Performance"
• CNBC News, 2002
• Theyre expensive, illusive, unregulated, and
  lack any credibility and opportunity. They were a
  fad and the fad has finished"
• Independent Investment Magazine, 2002

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Misconceptions About Opportunities

• "I think there is a world market for maybe five
  computers."
• Thomas Watson, chairman of IBM, 1943
• "There is no reason anyone would want a computer
  in their home."
• Ken Olson, president, chairman and founder of
  Digital Equipment Corp., 1977
• "This 'telephone' has too many shortcomings to be
  seriously considered as a means of communication.
  The device is inherently of no value to us."
• Western Union Chairman in response to his
  urgings for investment, 1876

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Misconceptions About Opportunities

• "Heavier-than-air flying machines are
  impossible."
• Lord Kelvin, president, Royal Society, 1895.
• "The concept is interesting and well-formed, but
  in order to earn better than a 'C,' the idea must
  be feasible."
• A Yale professor in response to Fred Smith's
  paper proposing reliable overnight delivery
  service.
• "Stocks have reached what looks like a
  permanently high plateau."
• Irving Fisher, Professor of Economics, Yale
  University, 1929.
• "We don't like their sound, and guitar music is
  on the way out."
• Decca Recording Co. rejecting the Beatles,
  1962

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Misconceptions About Opportunities

• The opportunity for growth will expire in 2056
  when the world population exceeds 100bn
• World Science Magazine, 1935
• Disease - Crash
• Weather - Blow-ups (LTCM)
• Genetics - Performance
• War - Regulation
• Always factors controlling growth

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Section 1 Summary

• Media fuels momentum (rightly or wrongly)
• Difficult to predict future opportunities
• Natural mechanisms to limit capacity.
• Q. How much has the industry grown?

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Hedge Fund Industry Growth
No. of Hedge Funds 7,200
Hedge Fund Assets gt1 trillion
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Hedge Fund Performance
Lacklustre performance reflects difficult market
conditions rather than capacity constraints
Ann. Rtn 14.37 Ann SD 6.93
Dynamic opportunities at the sub-strategy level
dictate performance
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Asset Weightings Capture Changing Opportunities
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Changing Opportunities reflected in Strategy
Performance
Hedge fund style returns show little consistency
from year to year
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Broad Range of Performance Across Strategies
Selecting the best strategy earns an average of
19 per year above an equally weighted portfolio
Selecting the worst strategy subtracts an
average of 22 per year from an equally weighted
portfolio
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Top Down Skills Help Capture Opportunities

• Strategy Selection

Eliminating the worst performing strategy adds
142
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Broad Range of Fund Performance
Selecting the top decile of funds earns an
average of 26 per year above an equally weighted
portfolio
Selecting the bottom decile of funds subtracts
an average of 27 per year from an equally
weighted portfolio
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Bottom Up Skills Help Capture Opportunities

• Manager Selection

Eliminating the bottom decile adds 157 over the
period
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Section 2 Summary

• Opportunities vary amongst sub-strategies
• Opportunities are dynamic
• Strategy dynamics are difficult to predict
• Active management boosts performance during
  periods of sub-strategy under-performance
• Q. Is strategy performance related to asset
  growth? Are we reaching capacity?

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Asset Growth vs. Performance
Convertible Bond Arbitrage
Performance not effected by asset growth but more
by market conditions
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US Convertible Market Growth
Global Convertible Market is gt 610bn in size
Source Morgan Stanley Convertible Research
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Asset Growth vs. Performance
Equity Hedge
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Asset Growth vs. Performance
High Yield
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High Yield Bond Debt Market
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Asset Growth vs. Performance
Fixed Income Arbitrage
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Section 3 Summary

• Asset growth has not been the primary cause of
  sub-strategy under-performance
• Market dynamics cause temporary
  under-performance
• Whilst there maybe limitations in capacity, we
  are a long way off
• Q. What are the current opportunities ?

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Current Opportunities In Hedge Funds
1. Short End Yield Curve
Return to Risk on US Treasuries
Opportunities exist but partly eroded
Source JP Morgan
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Current Opportunities In Hedge Funds
1a. Relative Value - Yield Curve
Yield curves move in a more predictable way
Yield curve trading is far from over but more
complex than before.
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Current Opportunities In Hedge Funds
2. Equity Anomalies

• Single stock momentum has decreased due to
  information efficiency
• Index entry/exist arbitrages away

Easy opportunities have been eroded
The size and nature of equity markets leaves
ample investment opportunities
Source JP Morgan
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Current Opportunities In Hedge Funds
3. Short End Credit Curve
Source JP Morgan
Excess Returns to Credit Risk at the Short End of
the Curve
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Current Opportunities In Hedge Funds
4. BB Mispricing
BB Sector offers higher return to risk
Source Merrill Lynch
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Current Opportunities In Hedge Funds
5. Foreign Exchange
Source Merrill Lynch

• Well known trading rules less efficient
• Carry and momentum trade remain intact

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Current Opportunities In Hedge Funds
6. Mispricings in Options
Options Implied vs. Actual Volatility
Swaptions Implied vs. Actual Volatility
Options offer good opportunities because of
segmentation (i.e. restriction on use)
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Emerging Strategies Provide Opportunities
240bn absorbed by new or emerging strategies
since 1990
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Emerging Strategies Provide Opportunities
Commodities as an alternative investment - OTC
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New Opportunities In Hedge Funds
Hedge Fund Derivatives Growth
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VIX Options Futures
New Opportunities In Hedge Funds

• Uses of VIX derivatives
• Hedging option volatility risk
• Taking a market view on the direction of
  near-term volatility
• Arbitrage opportunities between SP 500 options
  and VIX futures and options
• Volumes have increased 6 fold in the last 3-years
  (4.5tr)

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Credit Default Swaps (CDS)
New Opportunities In Hedge Funds

• Credit Default Swaps Facilitate
• Buying/Selling Protection on Individual Names
• Buy / Sell Protection on Bond Indexes
• Credit Default Swaps offer arbitrage
  opportunities
• Combining different Credit Default Swaps and/or
  securities in an effort to create arbitrage
  profits

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Conclusion

• Opportunities are dynamic (sub-strategy)
• Many new opportunities over time
• Periods of limited opportunities alleviated
• by active management
• Opportunities remain ample where
• New trading rules
• Advanced analytics
• New products
• New inefficiencies
• Performance could be related to asset
• growth, long way off in most strategies

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