1 The Benefits of Hedge Funds The First Seoul International Derivatives Securities Conference Thomas Schneeweis & Vassilis Karavas August 28, 2003

CISDM/UMASS-Amherst2 Outline  I. Introduction to Traditional and Alternative Investments  II. Benefits of Hedge Fund Investment  III. Hedge Funds in Asset Allocation

CISDM/UMASS-Amherst3 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

CISDM/UMASS-Amherst4 Introduction to Traditional & Alternative Investments Investment Alternatives Traditional Alternatives Private Equity Commodities Real Estate Modern Alternatives Hedge Funds Managed Futures Traditional Investments Stocks Bonds

CISDM/UMASS-Amherst5 What is a Hedge Fund? Term “Hedge Fund” is a misnomer with little descriptive power 1950’s: 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 2000’s: 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

CISDM/UMASS-Amherst6 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.

CISDM/UMASS-Amherst7 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

CISDM/UMASS-Amherst8 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.

CISDM/UMASS-Amherst9 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

CISDM/UMASS-Amherst10 Little Evidence of Equity Fund Alpha ( )

CISDM/UMASS-Amherst11 Little Evidence of Diversification Benefits Across Stock Markets ( )

CISDM/UMASS-Amherst12 Academic Evidence on Hedge Funds  Hedge funds and CTAs offer the potential for alpha (excess return relative to common benchmarks such as equal risk S&P 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

CISDM/UMASS-Amherst13 Evidence of Hedge Funds in Providing Diversification Benefits Relative to Stocks and Bonds ( )

CISDM/UMASS-Amherst14 II. Benefits of Hedge Funds  Why Hedge Funds?  Source of Hedge Fund Benefits  Analysis of Hedge Fund Returns

CISDM/UMASS-Amherst15  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. Why Hedge Funds?

CISDM/UMASS-Amherst16 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)

CISDM/UMASS-Amherst17 Hedge Fund Performance Indices  Active manager based peer indices (similar to Morningstar or Lipper Mutual Fund Indices) EACM CSFB/Tremont HFR CISDM MSCI S&P 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.

CISDM/UMASS-Amherst18 Hedge Funds: Return/Risk Performance

CISDM/UMASS-Amherst19 Hedge Funds Provide Higher Return Compared to Traditional Assets

CISDM/UMASS-Amherst20 Hedge Funds Provide Enhanced Return/Risk Performance

CISDM/UMASS-Amherst21 Hedge Fund Performance

CISDM/UMASS-Amherst22 Basis for Hedge Fund Performance

CISDM/UMASS-Amherst23 Tracking Factor Based Determinants of Hedge Fund Returns– US Case

CISDM/UMASS-Amherst24 European Hedge Fund: Factor Analysis – Tracking

CISDM/UMASS-Amherst25 Long/Short: Factor Analysis – Tracking

CISDM/UMASS-Amherst26 Tracking Style Based Determinants of Hedge Fund Returns US Case

CISDM/UMASS-Amherst27 Hedge Funds: Style Based Long Short Equity Tracking Tracking: Dow Jones Euro Stoxx 50, FTSE 100

CISDM/UMASS-Amherst28 Asset Allocation: Active Asset Management Strategic Asset Replacement Tactical Asset Management

CISDM/UMASS-Amherst29 Hedge Funds in Active Asset Allocation

CISDM/UMASS-Amherst30 Traditional Mean Variance Optimization with Hedge Funds Traditional Asset ClassesWeightsSub Total U.S. 30 Day TBill TR5.0% SB 1 Yr On-The-Run Treasury TR5.0%10% SB 3-7 Yr Treasury TR5.0% SB 10+ Yr Treasury TR10.0% SB Hi-Yld TR5.0% SB AAA/AA Corp TR10.0%30% Russell 1000 TR40.0% Russell 2000 TR10.0%50% MSCI EAFE TR5.0% MSCI Emerging Market Free USD5.0%10%

CISDM/UMASS-Amherst31 Hedge Funds Replace Traditional Assets Change in Allocation

CISDM/UMASS-Amherst32 Hedge Funds Replace Traditional Assets Change in Allocation

CISDM/UMASS-Amherst33 Hedge Fund Selection Determined By Economic Forecast

CISDM/UMASS-Amherst34 Tactical Asset Allocation: Hedge Fund Selection by Economic Forecast

CISDM/UMASS-Amherst35 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.