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Hedge Fund Overview
August 2003
Duane Hess CFA Partner ! I
Allan Martin, Senior Consultant
Bryan Schneider, Senior Analyst
''Advancing Your Investments"
NEW ENGLAND PENSION CONSULTANTS
One Main Street, Cambridge, Massachusetts 02142-1524
(617) 374-1300; F: (617) 374-1313
www.nepc.com
Where do Hedge Funds fit?
• Within a Broad range of "Non-Traditional" strategies
- Private Equity
• Venture, buyouts, restructurings, special situations
• Subordinated (mezzanine) debt
- Hedge Funds
• Merger arbitrage, convertible arbitrage, long/short
- Real Estate
- Natural Resources
• Oil & gas, timber, agriculture
- Managed Futures and Commodities
- "Other"
2 L:Clients:Okfahoma:Research:Asset Class: Hedge Funds
Financial Assets vs. Alternative Assets
High
Low
Early Stage Venture
Post Venture
Macro & Short Seller
Long-short
Index ARB Emerging Markets
International Stocks
Domestic Stocks
Expected Vo~atUity High
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Why bather?
• Managers have a chance to generate higher rates of return
in these more Inefficient Markets
- Fewer market participants
- Absence of timely information
- Dramatic supply/demand imbalances
- Increased opportunity set
- Ability to short securities
4 L:Clients:OkJahoma:Research:Asset Class: Hedge Funds
Challenging Features
• Fees are typically much higher than for traditional mgrs.
- Fee structures have improved over past ten years, and now better
align interests of manager with investors
• Fees often include
- Base fee
- Performance fee
- Clawback provision
• Excess performance fees paid during high return years are returned
("clawed back") to the investor during low return years
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Ho Alternative AdvisinQ)Differs
Traditional Assets Alternative Assets
Traditional tools (mean-variance optimization) and The lack of readily available and reliable data makes
Creating Program reliable inputs (historical data is readily available) allow modeling difficult and requires different, more time-for
easy oroaram modelina and construction consumina methods of oroaram construction.
Performance Data is readily available from manager and
Performance data is NOT readily available and indexes
Evaluating Performance useful indexes have been constructed to assist with
are either non-existent or not especially useful which
makes modeling and benchmarking much more difficult
modeling and benchmarking and time consuminq
Alternative managers have vast differences in their limited
Evaluating Legal Documents Most traditional manager documents are fairly boiler-plate partnership or other legal agreements with their investors;
and routine, with few differences between managers certain provisions can severely negatively impact
investors who fail to understand the legal agreement
Alternative Managers require significant back office
structures, employee compensation and retention
Traditional Managers have understandable and tested packages, client services and sound investment
Evaluating Organizational Structure structures in place to deal with all phases of their processes; though some firms can succeed while being
business from deal execution to marketing deficient in a few areas, few can thrive while being
deficient in all; Evaluating all these aspects is time
consuminq and costly
Alternative Managers' products may be available to the
public for only brief windows of time; and sometimes, they
Traditional Managers' products stay on the market will not accept new investors at all (meaning they open
Evaluating Available Products (though some Small Cap managers may close to new their funds only to existing investors); knowing who is or
investors periodically) for indefinite periods of time who soon shall be in the market is critical in terms of
knowing against whom evaluations of products should be
made
Evaluating Traditional Managers has become more Alternative Managers have traditionally catered to high net
routinized over the years with many managers adhering worth investors and have not yet fully adapted to
Due Diligence Required to AIMR PPS which allow more meaningful performance institutional needs in terms of procurement; further, few
comparisons; and such managers have simultaneously
adapted their RFP procedures to be more amenable to
have adopted AIMR PPS which makes performance
institutional investors
evaluation more difficult and time-consuming
Performance data is neither transparent nor readily
Monitoring Performance Data is transparent and readily available available; additionally, there is a lag in peformance data
and permits monitoring ease which makes monitoring more time consuming and
difficult
~ 6 LCfients:Oklahoma:Research:Asset Class: Hedge Funds
Hedge Fund Overview
• What are Hedge Funds?
- Private investment vehicles
• Usually a limited partnership format
• Can be domiciled in the U.S. or offshore
• Usually (but not always) involves leverage
• Usually (but not always) involves short selling
• Why do we like Hedge Funds?
- Attractive Returns
- Diversification Benefits
• What concerns us about Hedge Funds?
- Investment Risk (reality)
- Career Risk (perception)
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Hedge Fund Overview
Hedge Fund Style
I
I I I
I Relative Value I I Event-Driven I l Opportunistic 1
- Equity Market Neutral f0- Risk Arbitrage r- Macro
- Convertible Arbitrage '-- Distressed Securities - Short Sellers
- Fixed Income Arbitrage - Long Region,
Industry, or Style
- Emerging Markets
- Long/Short Equity
Low .~------------- Market Exposure ------ .~.• High
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Hedge Funds - Correlation to S&P 500
Annual Correlation to S&P 500 by Hedge Fund
Style Indices
(through 12/31/02)
1 Year 3 Years 5 Years 7 Years
Hedge Fund lndex ' 0.83 0.62 0.65 0.69
Market Neutral1 (0.48) (0.26) (0.14 ) 0.02
Event Driven" 0.51 0.49 0.52 0.54
Merger Arbitrage 1 0.62 0.41 0.56 0.55
Convertible Arbitrage 1 0.27 0.29 0.32 0.30
Macro Index2 (0.35) (0.02) 0.24 0.36
Equity Hedge (Long/Short)2 0.80 0.61 0.71 0.68
Fund of Funds2 0.47 0.38 0.47 0.53
1 Data from the Hennessee Hedge Index
2 Data from the HFRI Data Base
9 LClients:Oklahoma:Research:Asset Class; Hedge Funds
80
Relative Value Event Driven opportunistic
.................................................................................................................................................................................................................................................................................................................... c-- . .
60
40
20
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Source: Hedge Fund Research, Inc., January 1990 - March 2000; Returns reflect the average for the strategy;
individual funds variability will be greater
8
LClients:OkJahoma:Research:Asset Class: Hedge Funds
Hedge Fund Overview
• Benefits
- Potentially high returns
• Depends on strategy
• Wide difference from manager to manager
- Potentially low correlations
• Depends on strategy
• Wide difference from manager to manager
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Hedge Fund Overview
• Challenges
- Potentially opaque
• Many hedge fund managers refuse to divulge
- Holdings
- Transactions
- Portfolio characteristics
- Investment methodology
• Can be difficult to value
- Some strategies use lots of derivatives
- Some strategies use very illiquid securities
- Very difficult to monitor
• Often unregulated
• Instances of fraud
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Hedge Fund Overview
• The Transparency Issue
Many (but not all) hedge fund managers resist providing necessary
levels of transparency
• However, the number of transparent funds is growing
• Institutions are increasingly successful in demanding transparency
- But what is transparency?
• The ability to evaluate the manager
• The ability to evaluate the strategy
• The ability to evaluate portfolio exposures
- Transparency does not need to involve
• Automatic distribution of manager information
• Freely disseminating sensitive information
13 LClients:Oklahoma:Research:Asset Class: Hedge Funds
Hedge Fund Overview
• The Transparency Issue
- A legitimate fear from hedge fund managers is that competitors will
see their portfolio
• A reasonable concern for portfolios with short positions
• However, this can be mitigated by having clients sign Non-Disclosure
Agreements
- Unfortunately, this concern still does not obviate a fiduciary's need for
unbiased information regarding their portfolio
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Hedge Fund Overview
• The Transparency Tradeoff
- If investors rigidly demand full transparency
• There will be fewer managers to invest with
• The opportunity set might not yield as good performance
- If investors ignore the transparency issue, they risk
• Something blowing up in their face
• Explaining to outsiders (e.g. reporters) why the hedge fund manager
wouldn't disclose information
• Personal liability
- A balance needs to be struck, and both the hedge fund manager and
plan sponsor communities needs to adjust in order to make
alternatives work
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Hedge Fund Overview
• The Leverage Issue
- Leverage is the ultimate two-edge sword
• Can help boost return, but only by boosting risk
• Magnifies the potential outcomes
- Leverage means different things to different people
• Our concern is the cumulative exposure that an invested dollar generates
• Other measures involve looking at borrowing (if present), or long minus
short positions
- In general, NEPC is uncomfortable with
• Net leverage (longs - shorts) over 100%
• Gross leverage (longs only) over 200%
- If a manager's return comes predominantly from leverage, NEPC
would recommend against it
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Hedge Fund Overview
• The Leverage Issue - an Example
If you invest in a manager that sells short, you could get up to $3
invested for every dollar you commit
• Here's how
- The dollar pledged to the manager is invested long
- The long position is used for collateral for a short sale
- The proceeds from the short sale are then invested elsewhere
(usually cash, but can also be stock futures, etc.)
• This example does not involve borrowing or using derivatives
Many (but not all) managers make use of borrowing, as well
• Here's how
- The manager borrows money to invest alongside your assets (a
margin account)
- Depending on the arrangements, managers can borrow multiples of
their collateral
17 LClients:OkJahoma:Research:Asset Class: Hedge Funds
Hedge Fund Overview
• The Leverage Issue
- Derivatives (futures, options, swaps, structured notes, etc.)
• Can allow managers to obtain considerable market exposure by investing
only a fraction of the assets
• The good news is that this can offer the manager a cheap and easy way
to get market exposure
• The bad news is that it can allow managers to have market exposure far
greater than their collateral (think of Long-Term Capital)
- Derivatives use is very difficult to monitor and evaluate (again, think
of Long-Term Capital)
- In general, NEPC has shied away from derivatives-based hedge fund
strategies
• These tend to be the strategies that "blow up"
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Hedge Fund Overview
• Hedge strategies that NEPC has recommended
- Long/short
- Event Driven/Merger Arbitrage
- Convertible Arbitrage
- Market Neutral
- Fund-of-Funds
• NEPC has NOT recommended strategies with
- Excessive leverage
- Lack of transparency
- Short or inconsistent track records
- Unproven strategies
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Summary
• Hedge funds are growing rapidly
- NEPC suggests investments in strategies with
• Reasonably long, proven track records
• Stable organizations with qualified, reputable professionals
• In asset classes that have at least some existing institutional participation
• In strategies that best complement existing asset classes
• In ways that are consistent with industry best practices and all applicable
laws and regulations
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