The Benefits of Hedge Funds

1
The Benefits of Hedge Funds

• The First Seoul International Derivatives
  Securities Conference
• Thomas Schneeweis Vassilis Karavas
• August 28, 2003

2
Outline

• I. Introduction to Traditional and Alternative
  Investments
• II. Benefits of Hedge Fund Investment
• III. Hedge Funds in Asset Allocation

3
I. Introduction to Traditional and Alternative
Investments

• What Are Hedge Funds?
• Hedge Fund Facts
• Academic Evidence on Traditional Investment
  Performance
• Academic Evidence on Hedge Fund Performance

4
Introduction to Traditional Alternative
Investments
5
What is a Hedge Fund?

• Term Hedge Fund is a misnomer with little
  descriptive power
• 1950s A.W. Jones Model
• -Long/Short U.S. equities
• -Capture two opportunity sets while reducing
  overall market
• exposure
• -Hedge Fund term accurately reflected the
  underlying strategy
• 2000s Generic reference to a private,
  commingled vehicle
• investing in marketable securities
• -Strategy characteristics vary widely
• -Markets in which they participate vary widely
• -Risk/return characteristics vary widely
• -Common organizational and structural
  characteristics

6
What are Hedge Funds?

• Various Definitions
• A multitude of skill-based investment strategies
  with a broad range of risk and return objectives.
  A common element is the use of investment and
  risk management skills to seek positive returns
  regardless of market direction.
• A loosely regulated private pooled investment
  vehicle that can invest in both cash and
  derivative markets on a leveraged basis for the
  benefits of its investors.
• A hedge fund is a private investment portfolio,
  usually structured as a limited partnership, open
  to accredited investors, charging an incentive
  based fee, and managed by a general partner with
  every financial tool imaginable at his disposal.

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Hedge Fund Classifications

• Relative Value
• Market Neutral Equity (Long undervalued/short
  overvalued stock)
• Convertible Hedging (Long convertible.
  bonds/short stock)
• Bond hedging (Yield curve arbitrage)
• Event Driven
• Corporate transactions and special situations
• Deal Arbitrage (Long/short equity involved in
  corporate transactions)
• Bankruptcy/Distressed (Long securities involved
  in financial distress)
• Multi-strategy (Deal arbitrage and bankruptcy)
• Equity Hedge Funds
• Domestic Long (Long undervalued US equities)
• Domestic Opportunity (Long/Short Equity (long
  bias))
• Global Asset Allocators/Global Macro
• Systematic (trend-following or other quantitative
  analysis)
• Discretionary (Long or short markets based on
  fundamental analysis)
• Short Sellers

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Hedge Fund Facts

• Hedge funds are not riskier than traditional
  stock and bond investments
• Not all hedge funds are highly levered
• Most hedge funds trade in liquid and transparent
  markets
• Hedge fund strategies have existed for decades
• Hedge funds are not absolute return investments
  (e.g., make money in all markets) but do offer
  unique risk and return opportunities not
  available in traditional stock and bond markets.

9
Academic Evidence on Traditional Asset
Investment Performance

• Actively managed stocks and bond portfolios
  provide little alpha (excess return relative to
  benchmarks)
• With increased globalization, stock and bond
  investment provide limited diversification

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Little Evidence of Equity Fund Alpha (1996-2002)
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Little Evidence of Diversification Benefits
Across Stock Markets (1990-2002)
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Academic Evidence on Hedge Funds

• Hedge funds and CTAs offer the potential for
  alpha (excess return relative to common
  benchmarks such as equal risk SP 500 or Lehman
  Bond Indices)
• Hedge funds and CTAs offer the potential for
  diversification to existing stock or bond
  portfolios
• Multi-factor models which describe return process
  for stocks and bonds also describe the return
  process for hedge funds
• Modern methods of asset allocation used to
  deliver desired risk and return tradeoff for
  stocks or bonds can also be used for hedge funds

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Evidence of Hedge Funds in Providing
Diversification Benefits Relative to Stocks and
Bonds (1990-2002)
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II. Benefits of Hedge Funds

• Why Hedge Funds?
• Source of Hedge Fund Benefits
• Analysis of Hedge Fund Returns

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Why Hedge Funds?

• Hedge funds represent a large and growing
  industry that offers investors an opportunity to
  diversify and to earn competitive returns with
  low to moderate volatility.

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Source of Hedge Fund Benefits

• Unique Return Opportunities
• Strategy based
• Manager based
• Unique Diversification Opportunities (use wider
  range of instruments
• Different sources of return (long and short
  investing, concentrated asset positions)

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Hedge Fund Performance Indices

• Active manager based peer indices (similar to
  Morningstar or Lipper Mutual Fund Indices)
• EACM
• CSFB/Tremont
• HFR
• CISDM
• MSCI
• SP
• Zurich
• Note Academic research has shown that use of
  different indices may show different levels of
  risk and return benefits but basic conclusions
  are the same regardless of performance index used.

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Hedge Funds Return/Risk Performance
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Hedge Funds Provide Higher Return Compared to
Traditional Assets
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Hedge Funds Provide Enhanced Return/Risk
Performance
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Hedge Fund Performance
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Basis for Hedge Fund Performance
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Tracking Factor Based Determinants of Hedge Fund
Returns US Case
24
European Hedge Fund Factor Analysis Tracking
25
Long/Short Factor Analysis Tracking
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Tracking Style Based Determinants of Hedge Fund
Returns US Case
27
Hedge Funds Style Based Long Short Equity
Tracking

• Tracking Dow Jones Euro Stoxx 50, FTSE 100

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Asset Allocation Active Asset Management

• Strategic Asset Replacement
• Tactical Asset Management

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Hedge Funds in Active Asset Allocation
30
Traditional Mean Variance Optimization with Hedge
Funds
Traditional Asset Classes
Weights
Sub Total
U.S. 30 Day TBill TR
5.0
SB 1 Yr On-The-Run Treasury TR
5.0
10
SB 3-7 Yr Treasury TR
5.0
SB 10 Yr Treasury TR
10.0
SB Hi-Yld TR
5.0
SB AAA/AA Corp TR
10.0
30
Russell 1000 TR
40.0
Russell 2000 TR
10.0
50
MSCI EAFE TR
5.0

MSCI Emerging Market Free USD
5.0
10
31
Hedge Funds Replace Traditional Assets Change in
Allocation
32
Hedge Funds Replace Traditional Assets Change
in Allocation
33
Hedge Fund Selection Determined By Economic
Forecast
34
Tactical Asset Allocation Hedge Fund Selection
by Economic Forecast
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Conclusions

• Risk and Return Analysis That Works for
  Traditional Assets Works for Hedge Fund Analysis.
• Hedge Funds and CTAs Provide Risk And Return
  Opportunities Consistent With Their Exposure To
  Various Market Opportunities as well as Trader
  Skill.
• Modern Methods Of Asset Allocation That are Used
  To Determine Source of Return To Stocks and Bonds
  Can Be Used To Determine Source of Returns to
  Hedge Funds.