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

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

3. 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

4. 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

5. 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

6. 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.

7. 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

8. 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.

9. 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

10. CISDM/UMASS-Amherst10 Little Evidence of Equity Fund Alpha (1996-2002)

11. CISDM/UMASS-Amherst11 Little Evidence of Diversification Benefits Across Stock Markets (1990-2002)

12. 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

13. CISDM/UMASS-Amherst13 Evidence of Hedge Funds in Providing Diversification Benefits Relative to Stocks and Bonds (1990-2002)

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

15. 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?

16. 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)

17. 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.

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

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

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

21. CISDM/UMASS-Amherst21 Hedge Fund Performance

22. CISDM/UMASS-Amherst22 Basis for Hedge Fund Performance

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

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

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

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

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

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

29. CISDM/UMASS-Amherst29 Hedge Funds in Active Asset Allocation

30. 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%

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

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

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

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

35. 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.