Case for Alternative Alpha

Q1 | 2012The Case For Alternative AlphaBetter, cheaper, more liquid access to top hedge fund returns Historically, the only path for an investor to gain exposure to hedge fund “alpha” was to invest directly with a hedge fund or a hedge fund-of-fund. To succeed over the long term an investor had to either believe that they could gain access to top decile managers and choose well amongst them or, if not, believe that by giving up the selection responsibility to a fund of funds (for an extra layer of fees) the returns from expert selection would more than make up for the higher fees.Maz JadallahChief Executive Officer An entire industry has emerged around hedge fund managerAlphaClone LLC due diligence and selection. At one end are the consultants who help the endowments, institutions and family offices that can afford their services with customizing their hedge fund allocations to fit their specific needs. At the other are fund-of- funds who offer pre-packaged and managed allocations to specific hedge funds they select in exchange for an extra 1% per year and an extra 10% of new profits on top of the 2%/20% fees of the underlying funds. Elevating the price to the investor for incorrect manager selection is the fact they can not withdraw their investment at will. Hedge funds have “lockups” that range from 90 days to a couple of years or more which prevent an investor from redeeming their investment quickly. Simply put, when it comes to hedge fund investing, manager selection is everything. AlphaClone LLC | (415) 293-8388 | 1 Market St., Spear Tower 36 th Floor | San Francisco, CA 94105

Q1 | 2012Table 1: Average Hedge Fund The difficulty in manager selection and the lack of transparencyPerformance and returns persistence from hedge funds in general has led to the emergence of innovative investment products that offer1/00 to 7/11 HFRX:EH S&P500TRTotal Rtrn 49.37% 9.69% investors the opportunity to remove manager selection from the equation.Ann. Rtrn 3.52% 0.80%Volatility (ann) 7.52% 16.05% Tagged as “hedge fund alternative beta”, these products (manySharpe 0.34 -0.01 of which are available as ETFs) attempt to replicate the statistical return and risk characteristics inherent in an index of1YR Ann 0.24% 19.65% hedge funds. The premise is that by replicating the average3YR Ann -4.33% 2.92% return/volatility/skew characteristics of an index of hedge5YR Ann -1.40% 2.39% funds (i.e. the “beta” in a index of “alternatives”), investors canSource: Hedge Fund Research still achieve hedge fund “like” returns without the headaches of manager selection, fees and lockups.Table 2: Factor-Based Hedge FundReplication ETFs The problem however is that the average returns amongst an index of hedge funds are not very good (see table 1). Looking at Total Rtrn the investable variant of Hedge Fund Researchs Equity HedgeTicker Inception +/- S&P 500 Total Return Index (HFRX:EH), we see annualized returnsCSLS Mar 2010 -8.20% since 2000 of 3.5% significantly underperforming the S&P500QAI April 2009 -54.04% over the 1, 3, and 5 year periods.MCRO June 2009 -34.05%ALT Oct 2009 -32.40% One would expect an investor interested in hedge fundRALS Dec 2010 -17.24% exposure to seek investment returns of top decile hedge fundsPTO May 2008 -18.50% (sustained alpha) not mediocre average returns that underperform broad passive indexes (see Table 2). Much likeSource: Finviz.com; as of 2/8/2012 investing in private equity or venture capital funds, there is an extreme difference in performance between top decile and middles decile funds.Table 3: Effect of AddingAlternative Beta Allocation While alternative beta products can offer investors the lowAsset Port A PortB volatility and lower correlation benefits associated with hedgeUS Large Cap 30% 25% fund investing, there are arguably far more cost effectiveUS Small Cap 10% 10% methods to achieve those portfolio objectives. Adding an 15% 10% alternative beta allocation to a well diversified portfolioInternational rebalanced annually does not give an investor much to writeBonds 35% 25% home about irrespective of whether the analysis period includesSatellites (RealEstate, Commodities) 10% 10% the 2008 financial crisis (see Table 3).Factor-Replication 0% 20%Inception Pre-Crisis (3/31/08 to 1/31/12) “Alternative Alpha” Ann Vol% Ann RtrnPortfolio A 15.44% 4.11% Given the evidence, why then replicate beta exposure (i.ePortfolio B 17.24% 2.41% average returns) when you can just as easily replicate theInception Post-Crisis (1/31/09 to 1/31/12) “alpha” in the managers long positions instead? Replicating Ann Vol% Ann Rtrn hedge fund “long alpha” is possible because hedge fundPortfolio A 15.76& 18.19% holdings are disclosed regularly and their holding periods tendPortfolio B 13.18% 15.82% to be longer than most investors realize (see “5 Myths About Cloning Hedge Funds”).Source: iShares AlphaClone LLC | (415) 293-8388 | 1 Market St., Spear Tower 36 th Floor | San Francisco, CA 94105

Q1 | 2012 Satellites 10% The real challenge with “position replication” lies in the ability to continuously discern which managers/holdings to follow andEquity/US in developing a repeatable rules-based framework that can40% manage risks in all its forms including market (systemic) risk, Bonds regulatory filing risk, investment style risk, manager risk, 35% company (non-systemic) risk and geographic concentration risk to name a few. Separate Accounts Equity/Intl 15% By developing a series of “virtual fund-of-funds” around Figure A: Basic Allocation different investment styles and geographic exposures, AlphaClones Core Strategies are proven to give investorsAC ETF Ideas* intelligent “alternative alpha” replication products that, unlike25% “alternative beta” replication, have the alpha potential sought Bonds 35% by hedge fund investors. Designed to be versatile, AlphaClone Core Strategies can be used as core, replacement or supplementary components when constructing portfolios (see Figures A through D). AC Select AlphaClone Invest in a strategy that follows managers that have 20% AC Intl Select the highest Clone Score – a proprietary measure AC Momentum 10% developed by AlphaClone to identify managers 10% whos strategies perform the best when cloned. Figure B: Core Allocation Momentum Invest in a strategy that dynamically selects Select managers each quarter based on their performance Satellites momentum when cloned. 10% Bonds Value Masters Invest in the top consensus stock picks of the 35% worlds most well known value investors.AC Select International Invest the top consensus international holdings30% amongst AlphaClones hedge fund universe. Activist Masters Invest in the top holdings of the worlds most well Equity/Intl known activist investors. AC Momentum 15% 10% Figure C: Replacement ETF Ideas Invest in the top consensus ETF holdings amongst AlphaClones fund universe. Activist Masters AC Select 10% 15% SatellitesEquity/US 10% “Alternative Alpha” Index15% AlphaClones portfolio construction approach includes three basic elements; 1) position replication, 2) dynamic hedging, andEquity/Intl 3) automatic rebalancing. The three elements combine to take15% advantage of upside volatility, mitigate downside volatility and Bonds 35% Figure D: Supplement AlphaClone LLC | (415) 293-8388 | 1 Market St., Spear Tower 36 th Floor | San Francisco, CA 94105

Q1 | 2012Figure E: Distribution of Returns introduce rigid trading discipline. Now for the first time, weve # of months taking these principles and put them into a passive rules-based 30 index. 25 The AlphaClone Hedge Fund Long/Short Index [Bloomberg/ 20 Reuters tickers: ALPHACLN] seeks to track the performance 15 of US equities selected based on a proprietary Clone Score 10 methodology developed by AlphaClone. Completely rules- based, the index recalculates Clone Scores bi-annually and 5 rebalances long positions quarterly. 0 To manage downside volatility the index will employ a dynamic < -10% -3 to -2 -7 to -6 9 to 10 -5 to -4 5 to 6 1 to 2 -1 to 0 3 to 4 -9 to -8 7 to 8 hedge mechanism. The mechanism causes the strategy to vary monthly return % between being long only and “market hedged” depending on broad market index relative price targets. The mechanism isTable F: Performance vs Indices designed to reduce overall portfolio maximum drawdowns,Annualized Return % volatility and market correlations. 20% ALPHACLN 18% The strategys backtested performance since 2000 has returned 16% nearly 18% annualized since 2000 vs. 0.55% and 0.82% 14% annualized for the S&P500 and DJCS Long/Short Equity Index 12% respectively. The strategys monthly return distributions were 10% positively skewed and had low overall correlations (R 2) with 8% either benchmark index. 6% 4% 2% DJCS Equity L/S S&P 500TR Illustrating the effects of its dynamic hedge, the strategy was 0% able to capture a majority of the gains during rising markets 7% 9% 11% 13% 15% 17% (73% upside capture vs S&P 500) while avoiding a majority of Standard Deviation the losses during falling markets (37% downside capture vs S&PPerformance since inception 1/1/ 2000. Hedge fund 500). See Figures E/F and Table 4 for backtested performancebenchmark index is the Dow Jones Credit Suisse CoreEquity Long/Short Index results.Table 4: Annual Returns/Stats “Alternative Alpha” ETF ALPHACLN S&P 500 DJCS 2011 -3.1% 2.1% -3.3% 2010 16.0% 15.1% 4.9% In mid-2012, AlphaClone will be deploying an ETF based on the 2009 35.6% 26.5% 10.8% index above making the strategy easily accessible to investors in 2008 0.8% -37.0% -29.4% a relatively low cost and liquid form. The strategy is tailored to 2007 23.7% 5.5% 5.6% advisors and their clients who want access to top hedge fund 2006 31.2% 15.8% 8.9% 2005 21.0% 4.9% 4.5% performance in a “virtual fund of fund” strategy but without 2004 23.8% 10.9% 9.8% the high fees and lockups and with all the flexibility and 2003 41.5% 28.7% 17.6% scalability inherent in exchange traded funds. 2002 1.6% -22.1% -8.7% 2001 12.8% -11.9% -6.5% To learn more about our offering and to receive updates on our 2000 14.5% -9.1% 4.80% upcoming products please visit the url below to complete our Alpha (ann.) * 17.6% 17.4% contact form or visit our website at http://alphaclone.com. R2 * 0.18 0.27 Up Capture * 73.5% 235.5% Keep me updated - http://bit.ly/ymhzbMDown Capture * 37.2% 43.8%Max Drawdown -13.2% -50.9% -36.4% AlphaClone LLC | (415) 293-8388 | 1 Market St., Spear Tower 36 th Floor | San Francisco, CA 94105

Q1 | 2012 The information contained herein (the “Information”) may not be reproduced or re- disseminated in whole or in part without prior written permission from AlphaClone LLC. The Information may not be used to verify or correct other data, to create indices, risk models, or analytics, or in connection with issuing, offering, sponsoring, managing or marketing any securities, portfolios, financial products or other investment vehicles. Past performance is not a guarantee of future returns. AlphaClone Core Strategies seek capital appreciation as their investment objective. This communication does not constitute an offer or a solicitation to invest with AlphaClone, LLC. Backtesting is the process of evaluating a core strategy by applying it to historical data. Backtested performance results are provided for purposes of illustrating historical performance had a core strategy had been available during the relevant period. Backtested performance results are hypothetical and have inherent limitations. AlphaClone makes no representation that any core strategy will achieve performance similar to any backtested performance results. Actual results could differ materially from backtested performance and future results could differ materially from backtested performance. Past performance is no indication or guarantee of future results. Backtested performance results: (i) do not reflect the deduction of any management fees or trading commissions; (ii) are not based on actual trading and do not reflect any market impact of buying and selling securities, trade timing and security liquidity; (iii) are updated on a quarterly basis following the filing of public disclosure reports by certain hedge fund and institutional money managers; (iv) reflect the closing prices on the rebalance date; (v) reflect prices that are fully adjusted for dividends and corporate actions (e.g., stock splits); (vi) do not reflect any public disclosures filed after a rebalance date; (vii) reflect the historical results of securities which have been, been are no longer, publicly traded; and (viii) reflect the historical results of money managers who are no longer filing public disclosure reports. The AlphaClone core strategies are subject to change without notice and AlphaClone has no obligation to update you as to any such changes. The information provided herein comes from what AlphaClone believes to be reliable sources. AlphaClone, however, makes no representations as to its reliability or accuracy, and you should undertake independent analysis to ensure the accuracy of the information.AlphaClone LLC | (415) 293-8388 | 1 Market St., Spear Tower 36 th Floor | San Francisco, CA 94105

Case for Alternative Alpha

by AlphaClone on Dec 31, 2011

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Case for Alternative Alpha — Document Transcript

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