Hedge Funds Lecture 1: Overview Ezra Zask Yale University September, 2005

Definition Investment approach –A sub-set of alternative investments that incorporate all investment strategies run with an orientation to producing primarily absolute returns using largely marketable securities. –Strategies typically include short-selling and often include leverage –As a result, correlations with broader markets are expected to be modest to low. Legal Definition –Freedom from ICA (1940) controls on: Leverage short-selling cross-holding 10% limits incentive compensation derivatives positions –Limitations on: number of U.S. investors (99 maximum) solicitation of U.S. investors public advertising and disclosure

Institutional Allocation

Allocation Methodology

Impediments to Investing

Institutional Assets

Institutional Share of Assets

Long Only Managers

Structured Products

Asset Class Allocation by Institutional Investors Asset ClassPercent Allocation Equity51% Fixed Income17% Real Estate4% Hedge Funds15% Private Equity3.2% Venture Capital3.5% Natural Resources3% Source: NACUBO Endowment Study

Strategy Allocation StrategyAssets ($bln)Percent AssetsNumber Funds Long/Short Equity Hedge 28235%1148 Event Driven38.618%316 Other40.79%316 Fixed Income Arbitrage Global Macro32.68%146 Emerging Markets31.77%168 Market Neutral26.86%212 Convertible Arbitrage 22.25%124 Dedicated Short Source: Lipper/Tass

Hedge Fund Location LocationPercent Assets Cayman Islands35% United States32% British Virgin Islands8% Bermuda8% Bahamas4% Luxembourg3% Asia4%

S&P Hedge Fund Strategies

Strategy Definitions

Fixed Income Arbitrage

Convertible Arbitrage

Merger Arbitrage

Equity Market Neutral

Distressed Securities Strategy

Special Situations

Equity Long/Short

Managed Futures

Global Macro

Strategy Performance Conve rtible Arbitra ge Distre ssed Securi ties Emerg ing Market s Equity Hedge Equity Market Neutra l Event- Driven Fixed Incom e Arbitra ge Fixed Incom e Convt Bonds Fund of Funds MacroMerge r Arbitra ge Market Ti Relativ e Value Arbitra ge Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec

Strategy Performance (2) Mean Return (%) Standard Deviation (%) Sharpe RatioSkewnessKurtosisAlphaBeta HFRI Convertible Arbitrage TR HFRI Distressed Securities TR HFRI Emerging Markets Global TR HFRI Equity Hedge TR HFRI Equity Market Neutral TR HFRI Event-Driven TR HFRI Fixed Income Arbitrage TR HFRI Fixed Income Convt Bonds TR HFRI Fund of Funds TR HFRI Macro TR HFRI Market Timing TR HFRI Merger Arbitrage TR HFRI Relative Value Arbitrage TR

Style Risk Return

Style Correlations 1/1994-6/2005 Style Correlations Distressed Emerging Markets Equity Market neutralEvenMultiFixed Income MacroHF IndexFuturesFoF Distressed Index Emerging Markets Index Equity Market Neutral Index Event Driven Index Multi-Strategy Index Fixed Income Arbitrage Index Global Macro Index Hedge Fund Index Managed Futures Index Fund of Funds

CISDM Style Beta Analysis S&P 500Small CapS&P VolatilityImplied Vol Change in Implied Vol Yield Curve Slope Credit Risk Premium 10 Year Swap Spread Equity HedgeMMMHMMHM Relative Value Arbitra geMHHLMMHM Global MacroMHMLMMMM Fund of FundsMMMHMMHM Equity Market NeutralMMMMMLMM Convertible Arbitra geMHHLMLMH Fixed Income: Arbitra geMMHLMHMM

Hedge Fund Alpha