1 Hedge Funds: Issues for Institutional Investors Robert A. Jaeger, Ph.D Vice Chairman and Chief Investment Officer September 2005

2 Motives for Investing qPotential for m Attractive absolute return n LIBOR plus 3% to 8%, depending on risk tolerance m Volatility lower than standard equity benchmarks m Low correlation with standard markets, especially in down markets qAbove points apply to a diversified portfolio of hedge funds. Individual funds are substantially more risky.

3 Issues qReturn/risk profile m Historical m Expected m Sources of return and risk qLeverage and short selling qPerformance fees qTransparency qIs there a hedge fund bubble?

4 A Cautionary Note on Historical Data  Many databases suffer from biases that may skew the returns upward.  Survivor bias  “Bad news travels slow”  Many indexes show historical records that precede the construction of the index: these are purely hypothetical results.  EACM100 ® Index*  Public record since January 1996  100 managers covering all main strategies and sub- strategies  Qualitative manager screening *EACM100® Index – Onshore Funds was launched January 1, 1996.

5 Major Hedge Fund Categories More Risk Less Risk Relative value: long vs. short positions, minimal net market exposure. Event-driven: net long bias, emphasizing specific corporate transactions (mergers, acquisitions, reorganizations, etc.) likely to produce definable changes in value within a definable period (typically 3-12 months). Equity hedge funds: “micro” investors focused on stock selection and company analysis, enhanced with ability to use leverage and sell short. Global asset allocators: “macro” investors who can be long, short or neutral with respect to multiple markets (interest rates, currencies, equity indexes, commodities). Short sellers: net short, usually focused on US equities, designed as hedge against down markets.

6 Historical Risk/Return Characteristics January 1996 – July 2005 Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100 ® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100 ® Index Onshore Funds (January 1996 – December 2003) and EACM100 ® Offshore Funds (January 2004 – July 2005) See for more information regarding the EACM100 ® Index.

7 Performance in S&P 500 Negative Months US Equity (S&P 500 Composite) was down 38% of the months, with an average monthly loss of 3.9%. Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100 ® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100 ® Index Onshore Funds (January 1996 – December 2003) and EACM100 ® Offshore Funds (January 2004 – July 2005) See for more information regarding the EACM100 ® Index. January 1996 – July 2005

8 Two Kinds of Strategies  Many hedge fund strategies employ “enhanced active management”: traditional active management enhanced with short selling, leverage, and other techniques. For example:  Market neutral equity  Fixed income arbitrage  Equity hedge funds  Global macro investing  Some hedge fund strategies are genuinely distinctive, not based on traditional techniques. These strategies are important sources of liquidity for financial markets.  Convertible hedging  Risk arbitrage  Distressed debt

9 How Do Hedge Funds Make Money? qHedge funds make money the old-fashioned way: they take risk. qBeware of common stories that underestimate risk: m “They exploit market inefficiencies” – not enough to go around m “They supply liquidity to markets” – some do, some don’t m “They take advantage of manager skill” – there are many skilled managers in the long-only universe, and many hedge fund managers who are not as skilled as they think.

10 Do Hedge Funds Make Money?  Our working assumption is that hedge funds, in aggregate, do not make money.  Manager selection and strategy allocation are critical  Hedge funds are like venture capital: the object of the game is not to earn “the average return”

11 Risk Factors  General risks  Leverage  Concentration  Illiquidity  Market-related risks  Directional market risk  Non-directional systematic risks (“alternative betas”), e.g., Equity: long value vs. short growth, long small cap vs. short large cap Fixed income: carry trades: long higher risk vs. short lower risk Exposure to volatility and “trendiness”  Organizational risks  Small shops, smaller asset bases, shorter records  Blow-up risk, headline risk

12 Leverage and Short Selling qShort selling is sometimes designed to reduce risk, sometimes designed to enhance return, sometimes both. qLeverage definitely increases risk, may or may not increase return. qLevels of leverage vary by strategy. For most strategies, maximum leverage (gross exposure/net capital) is 2:1. Main exceptions: convertible hedging, fixed income arbitrage, global asset allocators. Note: leverage has to be adjusted for volatility of positions.

13 Performance Fees qMost hedge funds charge a combination of asset-based and performance-based fees, often 1% plus 20%, or more. qPerformance fees grant the hedge fund manager a “free call option” on the fund’s performance, may create an incentive to take incremental risk. qMost hedge fund managers are long-term greedy, not short-term.

14 qHedge funds generally offer much less transparency than traditional separately managed accounts. qMany institutional investors are overly obsessed with transparency, failing to distinguish between m Daily position and transaction reports and m Useful portfolio information qEven 100% transparency does not guarantee protection from problems. Staying out of trouble is much more important than getting out of trouble. Transparency

15 The Current Environment  Dramatic growth  8,000-10,000 hedge funds  1,000 funds of funds  $1 trillion in assets  Growth driven by:  Demand: the search for absolute return  Supply: the search for more money and more freedom  Recent returns below some people’s expectations  Are hedge funds destroying their own opportunities?

16 The Brain Drain  The world does not need 10,000 hedge funds. The number of funds has grown dramatically; the number of worthwhile funds has not  The “brain drain”: starting a fund is easy, succeeding is not. This applies even to “celebrity managers”  Beware of the “life cycle” myth: newer is better than older

17 The Currently Fashionable Cynicism  Recent returns have been poor.  There are too many funds.  Recent returns have been poor because there are too many funds.  Our view:  Returns have been in line with reasonable expectations.  There are too many funds  Some strategies face “crowding issue,” others do not.

18 Performance by Strategy Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Offshore Funds (January 2004 – July 2005) See for more information regarding the EACM100® Index. Source: EACM Advisors LLC and Standard &Poor’s 500

19 qIs there too much money chasing too few opportunities? Important to separate homogeneous strategies from heterogeneous strategies. m Homogeneous: Managers tend to “herd” around similar positions, e.g., convertible hedging, risk arbitrage, distressed debt. m Heterogeneous: Wide divergence among manager positions, e.g. equity hedge funds, global asset allocators. Beware of glib generalizations about “what hedge funds are doing.” m Homogeneous strategies are more vulnerable to “crowded trade” problem. qIf hedge funds were in business to exploit market inefficiencies, then growth would be a major problem. But: inefficiencies are not the drivers of return. Are Hedge Funds Destroying Themselves?

20 The Real Problems: Low Volatility and Low Dispersion Historical Volatility Implied VolatilityDispersion OEX Historical Index and Stock Volatility, Implied Index and Stock Volatility, and Cross-Sectional Volatility Source: Citigroup Smith Barney and the Chicago Board of Options Exchange

21 Did Hedge Funds Cause these Problems?  No – they would do this only if hedge funds, in aggregate, pursue contrarian trading strategies that act as a negative feedback loop in the markets. In fact, many hedge funds are more momentum-oriented, acting as a positive feedback loop.  Several years ago, hedge funds were blamed for adding to market volatility. You can’t have it both ways.

22 Which market has the highest return volatility? Panel A Panel B Panel C Panel D Hint: Standard deviation is not sensitive to the order of returns. Each panel represents the same number of observations, with the same starting and ending point of 100. The cumulative rate of return is 0.0%.

23 Conclusion  Hedge funds do offer the potential for an attractive return/risk profile.  The current environment does present some special challenges.  Investors need realistic expectations, steering a course between the exaggerations of the marketers and the exaggerations of the cynics.