What is today’s talk about?

Democratization of Hedge Funds Redefining Alpha and Beta in Hedge Fund Returns
Yazann Romahi, PhD, Managing Director Global Head of Research & Quantitative Strategies Asset Management Solutions, JPMorgan Asset Management 2013

What is today’s talk about?

Overview What is Alternative Beta Equity Based Hedge Funds
HFRI Merger Arbitrage HFRI Equity Hedge (Long/Short) HFRI Equity Market Neutral Index HFRI Short Bias Index HFRI Emerging Markets Index Fixed Income Hedge Funds HFRI Convertible Bond Arbitrage HFRI RV Fixed Income Corporate Index Alternative Beta – NOT hedge fund replication An aside: Reverse Engineering Your Competitors To Index or not to Index

Understanding alpha and beta
Risk premium: Beta is the return that can be explained by any systematic exposure to an economic risk premium Pre-1975 1975 1993 1997 Bogle launches first index fund Fama-French 3 factor model Carhart 4 factor model Stock selection Key to Equity Return Equity Beta as a Growth Risk Premium Investable Size & Value identified as separate risk premia Momentum described as a persistent risk premium α α α α β β βValue βSmall Cap β βValue βSmall Cap βMomentum Source: J.P. Morgan Asset Management. For illustrative purposes only.

Alternative Beta: Definition
Traditional Investments Alternative Investments Alternative beta captured through systematic risk exposures Traditional beta captured through systematic risk exposures Alpha (inclusive of the illiquidity premium) Alpha Alternative beta is defined as the returns to factor risks uncorrelated to market risk that can be captured through a systematic exposure to an alternative risk premium (often long/short) that forms a component of traditional hedge fund returns For illustrative purposes only.

What Alternative Beta is NOT!
Alternative Beta is NOT Hedge Fund Replication We will show in this presentation how a large portion of hedge fund returns can be captured through traditional beta exposures The aim of Alternative Beta is to capture the component of hedge fund returns that is a beta uncorrelated to traditional beta Just because hedge fund indices can be replicated does not mean that they should be replicated

Merger Arbitrage What is it? Source of “Alpha”?
Merger arbitrage involves the hedge fund manager buying into the stock of a company subject to a takeover bid while shorting the stock of the acquirer company Source of “Alpha”? Ability of manager to limit exposure to “failed” deals through research Effectiveness of “alpha” overlay limited due to necessity of portfolio concentration (there are typically investable deals globally at any one time)

What is Merger Arb? 3G Capital looked to acquire Burger King and made an offer on 2/9/2010 Given that this was a friendly deal with a high likelihood of success, the premium available was limited. We bought the stock at USD , selling it to 3G Capital for USD 24 The deal completed on October 20th and thus earned 1.7% While this may initially sound low, this was over a 2 month period roughly equating to an annualised figure of over 10% Price sold bought Source: Bloomberg October 2010 For illustrative purposes only. The inclusion of the securities mentioned above is not to be interpreted as recommendations to buy or sell.

Example of failed bid: MacArthur Coal
Peabody Energy make an unsolicited offer for MacArthur Coal on March 30, 2010 at $13 per share New Hope Corp counter on April 9, and 4 days later increase their bid by 7.44% to $14.50 per share Peabody Energy counter on May 10 with an offer of $16 After Australia introduces a 40% tax on mining profits, Peabody reduces its bid to $15 per share The board rejects the offer and MacArthur Coal drops to $10.10 As the market had been expecting counterbids, our entry price was at $14.80 bought Price Source: Bloomberg For illustrative purposes only. The inclusion of the securities mentioned above is not to be interpreted as recommendations to buy or sell. Past performance is not indicative for future performance. The Fund is an actively managed portfolio subject to change.

Why is there a risk premium?
Diversification is central to merger arbitrage – more names reduces idiosyncratic risk High levels of merger activity are positive for the strategy Average return to a merger arbitrage deal Update annually Source: MergerStat, Bloomberg, JPMAM. Jan 1999 to Jul For illustrative purposes only. Opinions and analysis are JPMAM’s judgment and can be subject to change without notice.

Types of merger activity
Deals completed with acquirer stock signals strong valuations When cash is cheap companies will prefer cash funded acquisitions over stock funded acquisitions Credit bubble – more cash deals Update quarterly – get Victor to update underlying spreadsheet Source: Bloomberg, JPMAM as at 31st March For illustrative purposes only. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice..

A diversified portfolio limits downside risk
Cash Mergers - Monthly Return of the strategy Stock for Stock Manager - Monthly Return of the strategy Return to merger arbitrage Return to merger arbitrage S&P Monthly Return S&P Monthly Return The evidence supporting the hypothesis that the merger arbitrage strategy is akin to a short put is weak. Source: MergerStat, Bloomberg, JPMAM. Jan 1999 to Jul Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice. 12 12

Diversification is key
While North American deals are most active in mergers and acquisitions, European and to a lesser extent Asia Pacific deals do provide a significant amount of diversification In the current environment, North American deals dominate the portfolio No. of deals On bloomberg: Type MA Click on 3) Activity Trend Tick deal count Change to 2) Region View and select North America, Asia Pacific (developed) and Western Europe Change period from 5YR to 12YR Change period to monthly View as table Source: Bloomberg. As at 31st March 2012. The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

Systematic merger arbitrage
Active Merger Arbitrage vs “Passive” Merger Arbitrage We create a portfolio of the merger arbitrage “risk premium” – an equally weighted portfolio of stocks subject to takeover (with the corresponding short) Return is leveraged by approximately 20% HFRI Merger Arbitrage Systematic merger arbitrage Return 7.77% 7.97% Risk 3.62% 5.30% IR 1.16 0.83 Drawdown 8.27% 12.57% Longest underperformance 21 Portfolio performance is calculated using a static weight of the asset illustrated above, monthly rebalancing gross of fees. Sources: J.P. Morgan Asset Management, Bloomberg. Analysis period January 1991 to December 2011. Past performance is not a guide to the future.

Understanding alpha and beta
Risk premium: Beta is the return that can be explained by any systematic exposure to an economic risk premium Pre-1975 1975 1993 1997 Bogle launches first index fund Fama-French 3 factor model Carhart 4 factor model Stock selection Key to Equity Return Equity Beta as a Growth Risk Premium Investable Size & Value identified as separate risk premia Momentum described as a persistent risk premium α α α α β β βValue βSmall Cap β βValue βSmall Cap βMomentum Source: J.P. Morgan Asset Management. For illustrative purposes only.

Equity Long Short Index is a combination of risk premia
Equity Long/Short index is essentially a combination of a number of factor risks: Static 75% weight to MSCI World Equal allocations to a number of risk premia including the value premium, size premium, momentum and minimum volatility The importance of understanding the nature of alternative beta allows the investor to distil the truly uncorrelated factor exposures from those that may be doubling up exposure elsewhere in the portfolio Portfolio performance is calculated using a static weight of the asset illustrated above, monthly rebalancing gross of fees. Past performance is not a guide to the future. Sources: JP Morgan Asset Management, Bloomberg. Analysis period January 1995 to December 2012.

HFRI Equity Market Neutral
Equity Market Neutral can be captured with an equal risk exposure to Market Neutral Value and Market Neutral Momentum. Coupled with a MSCI World Beta of 0.1, this gives us an R2 of 45%

HFRI Short Bias HFRI Short Bias can be captured with a full risk exposure to Market Neutral Value (100% gross leverage). In addition is an equity beta of Together, this gives us an R2 of 85%

HFRI Emerging Markets HFRI Emerging Markets can be captured with a full risk exposure to MSCI EM with a small bias to Momentum (market neutral) and Minimum Volatility (market neutral). R2 = 85.7%

HFRI Convertible Arbitrage
R2 = 67%. Long CB, Long HY and long Investment Grade Credit; Short Duration; Short Equity

HFRI RV Fixed Income Corporate Index
R2 = 68%. Long HY (mainly) with some Investment Grade Credit and Short Duration

Seeing through the alpha smokescreen . . .
Traditional Beta Alpha Alternative Beta Equity Premium Credit Premium Commodity (GSCI) Emerging Debt Small Cap Premium Value Premium Emerging Equity Commodities Roll Yield Relative Bond Yield Curve Convertible Arbitrage Equity Momentum Commodities Momentum Term Premium Forward Rate Bias Relative Bond Carry FX Momentum Manager Driven Non-systematic Idiosyncratic High Frequency REIT Merger Arbitrage Increasing order of complexity A significant amount of “alpha” from hedge funds can be attributed to systematic factors One of the advantages of investing in hedge funds is accessing these uncorrelated sources of risk premia We seek to provide a liquid, transparent alternative to access these uncorrelated sources of return For illustrative purposes only. The targets and aims provided above are the Investment Manager’s targets and aims only and are not part of the Funds investment objective and policy as stated in the Fund’s prospectus. There is no guarantee that these targets and aims will be achieved. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice. 29 29

Alternative beta have had low correlations to traditional beta
MSCI World MSCI EM WGBI High Yield EMBI GSCI Value -0.14 -0.13 -0.05 -0.09 -0.16 0.06 Momentum 0.30 0.22 0.04 0.12 0.14 0.01 Size 0.19 0.32 -0.07 0.31 Low beta / minimum volatility -0.51 -0.46 0.05 -0.36 -0.25 -0.06 Convertible bond arbitrage 0.13 0.02 -0.01 0.36 0.08 Systematic merger arbitrage 0.47 0.52 0.00 0.41 0.45 0.25 Long/Short G7 Term Premium -0.10 Long/Short G7 Carry 0.11 0.07 0.10 0.03 FX Carry 0.40 0.48 -0.03 0.39 0.26 FX Momentum Commodities Roll Yield 0.21 0.20 Commodities Momentum -0.02 0.16 Sources: J.P. Morgan Asset Management, Bloomberg, UBS Global Focus Convertible Bond index, Merger Stat, Citigroup WGBI Index. Analysis period January 1998 to December 2012.

Possible uses of alternative beta solutions
Question How can we help? Institutional client unable to access traditional alternatives due to high costs, illiquidity and/or a lack of transparency (manager risk) Ability to provide alternative solutions in a low cost, liquid, and transparent fashion Hedge Fund investor looking to increase the liquidity profile of their hedge fund investments Analyse current exposures in their portfolio. Help them understand what alternative factors they may already have and where additional exposure may be beneficial. When requiring liquidity, a core/ satellite approach to alternative beta / high conviction alpha may be appropriate, thus allowing the client to increase exposure to alternatives while maintaining liquidity. Hedge Fund investor in the process of searching for a high conviction manager and would like to hold the alternative beta exposure in the interim Liquidity allows users to access the hedge fund style while they search for a high conviction manager. Similarly, daily liquid vehicles can be used for factor timing. Source: J.P. Morgan Asset Management. For illustrative and discussion purposes only

Alternative Beta as a component of a hedge fund allocation
Alternative Beta can be used in a core/satellite approach to reduce the overall fee structure of the solution while improving its liquidity profile Alternative Alpha 1-2 managers Diversified by strategy and instrument 1-2 managers Diversified by attachment point and peril Alternative Beta Core Component in Alternative Beta A number of liquid hedge fund styles can be replaced by a lower cost, highly liquid component 1-4 managers Diversified by style and instrument Alternative Beta 1-3 managers Diversified by style and instrument 1-3 managers Diversified across markets Satellite exposures to idiosyncratic alpha Satellite exposures to managers that deliver true idiosyncratic risk or exposure to illiquidity premia 1-3 managers Diversified by style and market As of December 31, Allocations are made at the manager's discretion and can be changed without notice. Manager count does not include investments in internal programs and managed co-investments. Strategy allocation information is estimated through December 31, 2012 and has been rounded.

A large competitor Portfolio Factor Model Return 13.7% Risk 7.2% 8.1% Sharp Ratio 1.9 1.3 Max Drawdown 5.1% 7.1% Competitor’s excellent performance over the past 4 years can be entirely explained by a fairly simple bet as highlighted by the replication above The “Factor Model Portfolio” is a portfolio that is 2/3rds Investment Grade Credit (with the duration hedged out) plus 1/3rd High Yield (R2=76%). There does also appear to be some currency momentum trading in there as well and a small amount of infrastructure equity While we are not trying to detract from the fact that they successfully made that bet, the point is that it looks like they’ve had essentially one bet on for 4 years with a little bit of noise around it

What Makes a Good Benchmark?
Investable Appropriate Informed Opinion Unambiguous Specified in advance

Have we captured the merger arbitrage hedge fund style?
Merger arbitrage strategy since inception (*): HFRI ED: Merger arb index +15.83% (net of C share class fees) +15.26% (net of fees of typically 2/20) Beta to MSCI World is 0.09 Volatility is 2.95% compared to 15.80% for the MSCI World index Update the following excel file on the Bloomberg Terminal Product lang\syst\merger arb\data files: Merger Arb Backest_FINAL – ‘BB perf’ worksheet. Line chart – see slide 18 worksheet Performance since inception: Slide 18 worksheet See ‘Merger Arb’ for Fund/MSCI World data Source: HFR, JPMAM, Bloomberg. As at 30th April 2013. * Inception Date – July 2009, performance is cumulative. Fees and charges for the C share class as follows: No initial charge, 0.75% annual management and advisory fee, 0.20% operating and administrative expenses and no redemption charge. performance of the merger arbitrage strategy within the JPMorgan Funds - Systematic Alpha fund to 31/03/11 and actual performance of the JPMorgan Investment Funds – Global Merger Arbitrage Fund thereafter. The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus.

Appendix

Long/short equity: back-tested performance
In line with the hedge fund style, 2009 was poor However 2010 was positive and subsequent gains have taken the fund above its previous peak Historical performance analysis Live performance*→→ Periods to 30th April 2013 Equity Long/Short MSCI World Excess return (annualised) 6.0% 4.1% Risk 5.9% 16.0% IR 1.01 0.05 Maximum drawdown 10.9% 55.4% Beta -0.11 Line chart from Systematic Alpha vs MSCI World sheet Table from Longshort sheet Source: Factset, Bloomberg, J.P. Morgan Asset Management, 30th April 2013. For illustrative purposes only. Fund inception 1 July 2009. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The back-tested period consists of the performance of the Equity Long/Short (beta neutral) strategy. The model captures the alternative risk premia embedded in the style by going long value stock with positive momentum subject to quality constraints. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Past performance is not indicative of future results. MSCI: Morgan Stanley Capital International. *Performance includes backtested data from 31/01/96 to 30/06/09 and performance of the equity long/short strategy within the JPMorgan Funds - Systematic Alpha fund thereafter.

Equity Long/Short - diversified, systematic capture of risk premia
Value premium Momentum Risk Premium Strategy: Long “cheap” stocks, Short “expensive” stocks (as measured by P/E, Div Yld etc) These factors form the backbone of many quantitative & qualitative equity products and drive most equity investment philosophies. Return Chasing & Market Bias Strategy: Long positive earnings revision stocks, short negative revision stocks Buy stocks whose momentum is in the top decile while shorting those in the bottom decile Size premium Quality Risk Premium Strategy: Buy small cap stocks; short large cap stocks Behavioural bias Strategy: Long positions with decreasing accruals, short stocks with growing accruals; Long positions with low beta, short stocks with high beta For illustrative and discussion purposes only. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided above are the Investment Manager’s targets and aims only and are not part of the Funds investment objective and policy as stated in the Fund’s prospectus. There is no guarantee that these targets and aims will be achieved.

The Value Premium : 1927-present
Fama-French Value: 1927-present Academic explanations remain incomplete at best EMH: Fama-French describe it as a priced risk factor. They argue that stocks with high book-market are more likely to be subject to financial distress and more correlated to the business cycle Behavioral finance: the literature here suggests that cognitive biases underlying investor behaviour are at the root of the premium. Specifically irrational investors tend to have exaggerated hopes for growth/glamour stocks and overly pessimistic outlook on value stocks Outlook: The increasing prevalence of ETFs and of passive market investments is exacerbating the premium

The Value Premium : 1927-present
One of the most interesting aspects of the value premium is the positive skew it brings in addition to its positive excess return over time It should also be noted that as seen in the returns since 1927, the value premium has not diminished since Graham and Dodd’s 1934 treatise.

Fama-French Size Premium
Fama-French Size: 1927-present The size effect can go through long periods of underperforms Outlook: The growth of ETFs and the growing acceptance of beta is in fact exacerbating both the value and size premia

The Size Premium : 1927-present
Drawdowns are significant with long periods of underperformance However, as seen with the value premium, the size premium is a positively skewed strategy which has significant benefit in a portfolio of exotic beta

Momentum : 1927 - present Momentum exists in all financial time series
Fama-French Momentum: 1927-present Momentum exists in all financial time series The persistence of this anomaly is the biggest threat to EMH Behavioural finance advocates offer explanations based on non-rational behaviour generating abnormal inertia Outlook: Momentum generally performs poorly at market turning points The question going forward is whether we are entering into an environment with shorter economic cycles

Momentum Distribution and Skew : 1927-present
The momentum factor exhibits significant negative skew Can it therefore be considered compensation for bearing negative skew?

Momentum Backtest : 1990 – present
From 1990, redefine it in sector neutral, country neutral momentum The results are similar and the negative skew is still pronounced

Low Risk Investing – Beta and Volatility
The outperformance of low beta/volatility stocks over high beta/volatility stocks is one of the biggest challenges to CAPM Unsurprisingly, all explanations in the literature are behavioural based. Most active money is delegated to managers whose performance is measured relative to a market index. As these managers are usually limited in any leverage they may use, low beta stocks will therefore look risky. Investors tend to favour higher volatility stocks because they underestimate the risk of stocks that offer the allure of a really high payout – highly volatile stocks. An alternative but related explanation is that they favour stocks that consistently are in the news (typically high volatility stocks)

Low Beta as an Investment Signal
Creating a portfolio based on low beta stocks while hedging with high beta stocks add value though the turnover is relatively high The strategy experiences significant underperformance during “dash to trash” rallies Surprisingly, the strategy is also negatively skewed and the quintile dispersion is not monotonic as only the extremes appear to add value

Macro Based Risk Premia

Global Macro has Significant Dispersion Amongst Underlying Managers
In the macro space, there isn’t a single premium that can explain the style so we focus instead on understanding the different risk premia that exist Here we list a number of risk premia common in the macro space Bond Futures: Although the term premium is considered a traditional beta, converting this into a long/short duration neutral relative term premium transforms this into an exotic beta FX: One of the most commonly known behavioural biases in FX is the Forward Rate Bias. We implement this amongst both G10 & EM countries and build a relative momentum model to augment this Commodities: The term structure in commodities generally reflects both expected changes in spot prices as well as an insurance premium If hedgers are net short, the term structure is likely to be backwardated* and thus a long position will earn a risk premium Likewise, if hedgers are net long, then contango* is likely and thus short positions earn a risk premium *Please see the Glossary of Terms in Appendix. The aims and objectives provided above are the investments manager’s aims and objectives and do not necessarily reflect the investment objective and policy of the Fund as stated in the Prospectus. There is no guarantee that these aims and objectives will be achieved. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

The Macro risk premium in our strategy
Fixed income Long the long end of steepest curves and short the long end of the flattest curves Long the highest carry bond markets and short the lowest carry bond markets 7 developed bond markets Currency 10 developed market currencies – momentum and carry negatively correlated Momentum – Price Momentum to capture autocorrelation in price series and equity momentum to capture a flow proxy Carry – Forward rate bias: Long the highest yielding currencies with rising rates and short the lowest yielding currencies with decreasing rates 20 Emerging Market Currencies: Forward Rate Bias Strategy though no positions taken in currencies of countries where the CDS prices are implying an implied probability of default greater than 15% Commodities 20 commodities - constituents of GSCI and DJUBS indices Roll Yield – long backwardated commodities and short those in contango Momentum – Commodities exhibit the highest autocorrelation of all financial timeseries The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus.

Fixed Income Macro Premia
Fixed Income Backtest Performance Fixed Income live track record Annualised return 1.08% Volatility 1.49% Sharpe Ratio 0.73 For updating global macro performance, see Product Language, Systematic Alpha, Data Files – “GM PnL Backtest and Live xlsx” Since inception, the factors within the fixed income strategy have been giving offsetting signals. For this reason, risk taken within the strategy has been low, leading to performance that has been broadly flat. Source: Bloomberg, J.P. Morgan Asset Management, as at 30th April Fund inception 1 July For illustrative purposes only. Past performance is not indicative of future results. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Performance includes backtested data from 31/12/94 to 30/06/09 and performance of the Fixed income strategies within the JPMorgan Funds - Systematic Alpha fund thereafter.

FX Macro Premia FX G10 backtest & live performance
FX EM backtest & live performance Annualised return 4.46% Volatility 5.03% Sharpe Ratio 0.89 Annualised return 5.41% Volatility 5.00% Sharpe Ratio 1.08 For updating global macro performance, see Product Language, Systematic Alpha, Data Files – “Global Macro PnL Backtest and Live xlsx” Source: Bloomberg, J.P. Morgan Asset Management, as at 30th April Fund inception 1 July 2009 For illustrative purposes only. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Past performance is not indicative of future results. *Performance includes backtested data from 31/04/91 to 30/06/09 and performance within the Systematic Alpha Fund thereafter.

Commodity Macro Premia
Commodity Backtest performance In the past, a significant proportion of the roll yield could be captured by being long the commodity due to most commodities being in backwardation. This is no longer true, with most commodities today being in contango. Indeed the most backwardated commodity is soybeans, with an annualised yield of 14.8%. In comparison, the commodity in greatest contango, lean hogs, has a negative yield of 33.9%. Annualised return 4.39% Volatility 5.00% IR 0.88 For updating global macro performance, see Product Language, Systematic Alpha, Data Files – “Global Macro PnL Backtest and Live xlsx”. Update text monthly. Source: Bloomberg, J.P. Morgan Asset Management, 28th February 2013. For illustrative purposes only. Past performance is not indicative of future results. Fund inception 1 July The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward.

More on CBs

What is a convertible bond?
Equity Option Debt Debt Characteristics: Principle repayment at a future date Periodic coupon payments Priced as a percentage of par Often “puttable” at investor’s option Often callable at issuer’s option Equity Option Characteristics: Conversion into shares during the life of the bond Fixed conversion price, at a premium to the current share price Fixed number of shares per bond Source: KBC Financial Products

Spectrum of convertible profiles
Convertibles can exhibit a number of different profiles, depending upon the value of the embedded optionality Equity-like Option is in-the-money, and these securities exhibit a high degree of equity sensitivity. Equity-like convertibles are most exposed to changes in the underlying share price Balanced Provide a mixture of equity and credit exposure. The convertible will be trading slightly above the bond floor, which will provide some protection on the downside if equity prices decline; in a positive scenario, delta will increase quickly and the optionality will increase in value, providing significant upside participation Bond-like Option is significantly out-of-the money and the probability of conversion is low. These securities have little equity sensitivity, and the primary driver of returns is the coupon and yield to maturity, as well as any changes in credit conditions Theoretical convertible payoff curve Bond Floor Conversion Premium Convertible Price Parity Bond-like convertible Balanced convertible Equity-like convertible Equity price Convertible price Definitions: Equity-like = vanilla convertibles with premium < 15%; Balanced = convertibles with a premium < 100% and an annualised premium < 20%; Bond-Like = convertibles with a premium > 100% or annualised premium > 20%

Convertible Bonds : A Hybrid Asset Class
Convertible Bonds are a hybrid asset class made up of several risk premia: High Yield Small Cap Premium Equity Risk Premium Embedded Optionality (can be considered a liquidty risk premium) Portfolio performance is calculated using a static allocation based on the weights illustrated above with monthly rebalancing and gross of fees. Sources: Please see disclosure slide for data sources: Analysis period January 1994 to December 2011. Past performance is not a guide to the future.

Convertible bond arbitrage
Convertible Bond (CB) arbitrage is a hedge fund style where, like merger arbitrage, there exists a common risk factor amongst the participants. CB’s trade at a discount to the sum of its parts – straight bond plus a call option on the underlying. The premium is essentially an illiquidity and small cap. premium. To eliminate this, the arbitrageur will typically look to hedge the equity and duration sensitivity. Convertible bond arbitrage MSCI World Return 6.1% 3.3% Risk 7.8% 16.3% IR 0.78 -0.01 Drawdown 19.7% 55.4% Correlation matrix MSCI World MSCI EM WGBI High Yield EMBI GSCI Convertible bond arbitrage -0.02 0.05 0.16 0.28 0.24 0.04 Portfolio performance is calculated using a static allocation based on the weights illustrated above with monthly rebalancing and gross of fees. Sources: Please see disclosure slide for data sources: Analysis period January 1994 to December 2011. Past performance is not a guide to the future.

Cross-Correlation between and within traditional and alternative beta
MSCI World Value Mom. Size Min. Volatility Merger Arb. WGBI EMBI Term Prem. Real Yield High Yield Convert. Arb. REITs GSCI 1.0 -0.2 Momentum -0.3 -0.1 0.1 -0.4 Minimum volatility 0.0 Merger arb. 0.4 0.3 0.2 0.5 G7 Term Premium -0.0 G7 Real Yield High Yield (spread) 0.6 Convertible bond arb. REITs (beta hedged) Sources: Please see disclosure slide for data sources: Analysis period January 1991 to December 2011.

Bibliography

Bibliography [1] Jegadeesh, Narasimham, and Titman, Sheridan, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance 48, [2] Fama E F and K R French, 1992, "The Cross-Section of Expected Stocks Returns", Journal of Finance 47, [3] Jaeger, Lars and Wagner, Christian, “Factor Modeling and Benchmarking of Hedge Funds: Can Passive Investments in Hedge Fund Strategies Deliver?”, Journal of Alternative Investments [4] Ang, Andrew, Robert J. Hodrick, Yuhang Xing & Xiaoyan Zhang (2006), The cross-section of volatility and expected returns, Journal of Finance, Vol. LXI, No. 1, February 2006, pp [5] Black, Fischer, Michael C. Jensen, and Myron Scholes (1972), The capital asset pricing model: some empirical tests, Studies in the theory of capital markets (Praeger) [6] Fama, Eugene F., and James D. MacBeth (1973), Risk, return and equilibrium: Empirical tests, Journal of Political Economy 71, pp [7] Blitz David C and van Vliet Pim (2007), The volatility effect: lower risk without lower return, Journal of Portfolio Management [8] G Jensen and J Rotenberg, “Hedge Funds Selling Beta as Alpha” (2003) 63

Bibliography (cont) [9] Agarwal V, Fung W, Loon Y C, Naik N, “Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market”, London Business School Working Paper, 2006 [10] Bohn, Henning & Tesar, Linda L, "U.S. Equity Investment in Foreign Markets: Portfolio Rebalancing or Return Chasing?," American Economic Review, American Economic Association, vol. 86(2), pages 77-81, May. [11] Victor L. Bernard and Jacob K. Thomas , “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings”, The Journal of Accounting and Economics, Volume 13 (1990), [12] Sloan. (1996). Do Stock Prices Fully Reflect Information in Cash Flows and Accruals About Future Earnings. The Accounting Review, Volume 71, Issue 3 (July, 1996), [13] Xie. (2001). The Mispricing of Abnormal Accruals. The Accounting Review, Volume 76, Issue 3 (July, 2001), [14] Vikas Agrawal, William H. Fung, Yee Cheng Loon, and Narayan Y. Naik, "Risks in Hedge Fund Strategies: Case of Convertible Arbitrage“, London Business School Working Paper, 2006 [15] Fan Yu, “How Profitable Is Capital Structure Arbitrage?”, Financial Analysts Journal, September 2006, Vol. 62, No. 5: 64

Bibliography (cont) [16] Gurdip Bakshi & Nikunj Kapadia, 2003."Delta-Hedged Gains and the Negative Market Volatility Risk Premium,“, Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 16(2), pages [17] Ser-Huang Poon, Clive Granger, "Practical Issues in Forecasting Volatility", Financial Analysts Journal, Vol 61(1), [18] Bollerslev T, Gibson M, Zhou H (2006), “Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option Implied and Realized Volatilities”, AFA Boston Meetings Paper 2006. [19] Canina L. and S Figlewski, (1993), “The Informational Content of Implied Volatility”, Review of Financial Studies, Vol 6(3), pp [20] Jorion P, (1995), “Predicting Volatility in the Foreign Exchange Market”, Journal of Finance, Vol 50(2), pp [21] Galati, G and K Tsatsaronis, (1996), “The information content of implied Volatility from Currency Options”, Bank of International Settlements [22] Amin K.I and V.K. Ng, (1997), “Inferring Future Volatility from the Information in Implied Volatility in Eurodollar Options: A New Approach”, Review of Financial Studies, Vol 10, No. 2, pp [23] Christensen, B.J and N.R. Prabhala, (1998), “The Relation Between Implied and Realized Volatility”, Journal of Financial Economics, 50, pp [24] Bollen N, Whaley R, (2004), “Does Net Buying Pressure Affect the Shape of the Implied Volatility Functions?”, Journal of Finance, vol 59(2), pp 65

What are we doing at JPMorgan?
Focusing on the creation of liquid vehicles to enable access to alternative beta Creation of multistrategy diversified solutions for those wanting diversified liquid alternatives exposure Recent media interest has resulted in more interest Significant coverage in prominent media such as NRPN and FTfm, IPE amongst others

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What is today’s talk about?

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Presentation on theme: "What is today’s talk about?"— Presentation transcript:

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