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  • 1. Alternative Investment Solutions
  • 2. Contents
    • Hedge fund industry characteristics
      • size, shape and implications
      • risk, return and correlation role within a traditional portfolio
    • Fund industry analysis
      • basic strategy classifications and return sources
      • drivers of opportunity and risk
      • enhanced strategy classifications
    • Research philosophy
      • strategy research example
  • 3. Contents (Continued)
    • Investment process
      • strategy clusters, operational due diligence cluster, asset allocation cluster and risk management cluster
    • Client related topics
      • mandate discussions
      • issues surrounding transparency
      • post 1998 environment
      • regulatory environment
      • industry maturation
      • expectations and tolerances
    • Conclusion
  • 4. Growth of the industry The Hedge Fund industry continues to grow as more investors allocate to the asset class Source: Hedge Fund Research, Inc. $38,190 $58,370 $95,720 $256,720 $817,492 $889,838 (E) $536,060 $622,304 $185,750 $487,580 $456,430 $456,430 $374,770 $367,560 $167,790 $0 $100,000 $200,000 $300,000 $400,000 $500,000 $600,000 $700,000 $800,000 $900,000 $1,000,000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 ASSETS (USD MILLION) GROWTH OF HEDGE FUNDS (1990 - 2004) $8,463 $27,861 $36,918 ($1,141) $14.698 $57,407 $91,431 $4,406 $54,847 $20,353 $46,544 $99,436 $75,084 $46,588 As of Q3 ESTIMATED ASSETS NET NEW MONEY PER ANNUM
  • 5. Hedge fund industry Hedge Funds capital flows are dynamic, and require an understanding of strategies COMPOSITION IN 1990 COMPOSITION IN 2004 Source: Hedge Fund Research Source: Hedge Fund Research Raffaldini ppt.xls*Pies?Chart 2 Raffaldini ppt.xls*Pies?Chart 1 Raffaldini ppt.xls*Pies?Chart 1
  • 6. Hedge funds in a traditional portfolio Whilst effect of adding hedge funds is to increase return in long-term, emphasis is placed on reducing volatility, due to hedge funds’ lack of correlation with traditional investments ANNUALISED RISK RETURN CHART (JANUARY 1990 - DECEMBER 2003 INCLUSIVE) Source: Bloomberg, Hedge Fund Research Inc. Correlation of HFRI Fund of Funds Index - to MSCI World: 0.42 - to JP Morgan Global Bond Index: -0.07 - to 50% MSCI World, 50% JPM GBI: 0.34 Graph is grouped objects 11% EQUITIES MSCI World Equity Index (r = 4.40%, v = 14.96%) 5% 6% 7% 8% 9% 10% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% VOLATILITY COMPOUND ANNUAL RETURN 4% BONDS JP Morgan Global Bond Index (r = 8.01%, v = 6.28%) BLENDED PORTFOLIO 50% JPM GBI 50% MSCI World (r = 6.50%, v = 8.63%) HEDGE FUNDS Hedge Fund Research Inc. Fund of Funds Index (r = 10.28%, v = 5.75%) BLENDED PORTFOLIO WITH HEDGE FUNDS 40% JPM GBI 40% MSCI World 20% HFRI FoF Index (r = 7.31%, v = 7.37%)
  • 7. Upside participation and loss avoidance Hedge funds seek to preserve capital during down months for equities while attempting to benefit from some of the gain in up months PERFORMANCE COMPARISON OF THE HFRI FUND OF FUNDS INDEX DURING POSITIVE AND NEGATIVE MONTHS OF THE MSCI WORLD EQUITY INDEX JANUARY 1990 - DECEMBER 2003 Average monthly return during 70 negative months for MSCI World Average monthly return during 98 positive months for MSCI World Source: Bloomberg, Hedge Fund Research Inc. Graph is grouped objects -3.59% 3.34% 0.10% 1.35% (5.00%) (4.00%) (3.00%) (2.00%) (1.00%) 0.00% 1.00% 2.00% 3.00% 4.00% MSCI World HFRI Fund of Funds Index
  • 8. Risk control in stress markets Reduction in volatility is achieved because hedge funds typically hedge against market risk SEPTEMBER 2001 RETURNS Graph is grouped objects, ungroup first to edit Source: Bloomberg, Hedge Fund Research Inc. 0% -14% -12% -10% -8% -6% -4% -2% -20% -18% -16% HFRI Fund of Funds Index S&P 500 Index NASDAQ Russell 2000 Index MSCI World
  • 9. Consistent performance Excess return in hedge funds during this period is achieved not by out-performing in good years, but by preserving capital in bad years, resulting in much lower volatility Source: Bloomberg, Hedge Fund Research Inc. ANNUAL RETURNS OF MSCI WORLD AND HFRI FUND OF FUNDS INDICES JAN 1990 TO DEC 2003 ANNUAL RETURN (%) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 HFRI Fund of Funds Index (10.3% p.a. return, 5.8% volatility) MSCI World (4.4% p.a. return, 15.0% volatility)
  • 10. How is this achieved?
    • Risk control is absolutely paramount. The emphasis is on capital preservation, with loss defined as loss of capital, not under-performance of a benchmark
    • The key to understanding this is to appreciate the compensation schedule for a hedge fund manager:
      • a management fee, usually around 1%
      • an incentive profit fee, usually around 20% of net new high profits
    • The compensation schedule has a profound affect in avoiding loss thereby creating a non-symmetrical risk-return distribution
    • Furthermore, unlike relative return (benchmark managers), hedge funds seek to produce absolute return
    • In the event that market conditions are difficult, they can simply raise cash and reduce exposure unlike traditional strategies
    Loss avoidance is everything
  • 11. Basic classifications The hedge fund industry has developed a diverse set of strategies and styles to generate returns Company-specific research (Information) Liquidity provision (Risk premia) Merger and Credit arbitrage spreads (Risk premia) Price Pattern (Behavior) Event Driven Relative Value Equity Hedged Trading
  • 12. Drivers of risk and return
    • Hedge funds attempt to create returns through
      • Capturing market risk premia
      • Exploiting market inefficiencies
    • Risk premium exists to compensate participants for assuming risk due to uncertainty
    • Markets are inefficient, generally in small ways in many places
      • Information
      • Market structure
      • Liquidity
      • Behavior
    • Skilled operations with the proper tools may take advantage of the opportunities
  • 13. Strategy classifications Importance to delineate into the sub-strategy level given differing sources of risk and return drivers Note: These are the strategy groupings used by Alternative Investment Solutions
    • Fixed Income Arbitrage
    • Statistical Arbitrage
    • Convertible Bond Arbitrage
    • Volatility Arbitrage
    • Fundamental Conservative
    • Fundamental Aggressive
    • Fundamental Short Bias
    • Event Equity
    • Opportunistic Trading
    • Systematic Long / Short
    • Merger Arbitrage
    • Credit Long / Short
    • Distressed / High Yield
    • Multi-Strategy
    • Other RV / ED
    • Systematic
    • Discretionary Global Macro
    • Discretionary Specialized
    • Emerging Markets
    EQUITY HEDGED TRADING RELATIVE VALUE / EVENT DRIVEN
  • 14. Research platform Independent research platform integrates strategy (top-down) and manager (bottom-up) analyses MANAGER RESEARCH MANAGER RESEARCH STRATEGY RESEARCH
  • 15. Investment process Manager Approval Committee 1 A grees upon a recommended list of managers for portfolios Investment Committees Constructs portfolios based on specific risk and return targets as it relates to the portfolio mandate Strategy Clusters Undertakes research that generates recommendations on managers within context of peer group Operational Due Diligence Cluster Evaluates the various non-investment related risks Asset Allocation Cluster Generates recommendations on portfolio structure Risk Management Cluster Ensures risks within portfolios are understood, intended and compensated Notes: 1 Does not make portfolio-specific decisions
  • 16. Strategy Cluster
    • Research is underpinned by an in-depth understanding of strategy drivers and manager differentiation
    • Clusters allow global participation and coordination of research effort, with resources allocated along “like skill sets” grouping of strategies
    • Thorough and efficient research designed to provide forward-assessment of manager risk and return expectations
    Objective: Undertakes research that generates recommendations on managers within context of peer group
  • 17. Responsibilities of the Strategy Clusters Follow-up meetings Initial Meeting STRATEGY RESEARCH SOURCING PRIORITIZING Continuous review of dynamic factors underlying each strategy’s risk and opportunity set Organize prospects in order of importance Establish general overview Gain comprehensive understanding Compare managers against industry peers on risk and performance measures MANAGER RESEARCH Managers allocated to a lead SIO and/or IO Identify potential new managers Sponsored by CIO or SIO Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster On-going manager monitoring to generate buy, hold or sell recommendation PEER ANALYSIS MANAGER MONITORING MANAGER RECOMMENDATIONS Manager Approval Committee Investment Committee
  • 18. Operational Due Diligence Cluster
    • Determine whether existing infrastructure enables the manager to focus on generating returns
    • Assess the scalability of the operations relative to the strategies employed
    • Establish a channel of communication between Alternative Investment Solutions and the hedge fund back office operations
    • Establish an understanding of information and timelines expected
    Key points include: Objective: evaluates the various non-investment related risks Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster Manager Approval Committee Investment Committee
  • 19. Responsibilities of the Operational Due Diligence Cluster RECEIVE FUND OVERVIEW Receives overview of the manager from respective strategy cluster Instigate independent UBS security checks IO’s generate and submit a report to the Manager Approval Committee Meet senior members of the manager’s logistics teams DUE DILIGENCE QUESTIONNAIRE Send questionnaire to manager and review once returned Regular monitoring and discussions with the manager Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster Manager Approval Committee Investment Committee SECURITY CHECKS MANAGER MEETING REPORT GENERATION MONITORING
  • 20. Manager Approval Committee
    • Draws on the output from the Strategy and Operational Due Diligence Clusters
    • Committee comprises the Senior Investment Officers of the group and is chaired by CIO
    • Committee meets formally on a monthly basis
      • Discusses and debates occur informally on an intra-month basis
    • Managers are approved by a two thirds majority where a quorum is defined as a minimum of four voting members
    • The Committee also determines managers to be removed from the recommended list
    Objective: agrees a recommended list of managers for portfolios Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster Manager Approval Committee Investment Committee
  • 21. Asset Allocation Cluster
    • Iterative approach considering manager availability, strategy research and macro-economic views
    • Recommendations on strategy allocation framework based on economic considerations, strategy developments and risk
    • R ather than rely solely on traditional mean variance optimization, strategy recommendations also utilize other quantitative techniques
      • This avoids problems inherent in historical modeling that occur when faced with non-predictive factors
    Objective: generates recommendations on portfolio structure Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster Manager Approval Committee Investment Committee
  • 22. Responsibilities of the Asset Allocation Cluster MACRO ENVIRONMENT STRATEGY OPPORTUNITIES RISK/REWARD ANALYSIS ASSET ALLOCATION RECOMMENDATION Qualitative assessment of strategy opportunity set Assess global macro economic trends Estimate risk/reward for each strategy Develop asset allocation recommendation for each unique mandate Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster Manager Approval Committee Investment Committee
  • 23. Risk Management Cluster
    • Assesses the balance of risk and reward within the portfolio in both normal and stress market conditions
    • Relevant risk factors are gathered in order to analyze fund performance and risk at both manager and portfolio level
    • Qualitative and quantitative analysis increases the robustness of the portfolio construction process
    Objective: ensures risks within portfolios are understood, intended and compensated Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster Manager Approval Committee Investment Committee
  • 24. Responsibilities of the Risk Management Cluster QUANTITATIVE MANAGER REVIEW QUANTITATIVE PORTFOLIO REVIEW RISK ASSESSMENT SCENARIO/STRESS ANALYSIS Performance-based analysis of portfolio risks, and the relation between investments Analytical decomposition of fund performance Aggregate components of manager risk and at the portfolio level Multifactor models to explain performance in normal and stress environments Strategy Clusters Ops. Due Diligence Cluster Asset Allocation Cluster Risk Management Cluster Manager Approval Committee Investment Committee RISK LIMIT OVERSIGHT Continuously monitoring of actual versus targets, benchmarks and peers PORTFOLIO RECOMMENDATIONS Quantitative recommendations regarding incremental portfolio risk of an investment
  • 25. Mandate discussion
    • Establish expectations for return, risk and correlation (both for normal market environments and stress)
    • Client constraints are established, examples include
      • strategy exposure
      • types of managers
      • manager concentration
    • Controlling risk is much easier than controlling return
      • Alternative Investment Solutions considers itself a risk manager that manages a portfolio rather than a portfolio manager that manages risk
  • 26. Issues surrounding transparency
    • Question comes down to risk measurement versus risk management
      • Hedge fund managers generally reluctant to provide full disclosure given that other market participants can use this information to their advantage
        • particularly relevant when short positions, controversial and illiquid securities are involved
    • What level of disclosure is necessary to perform effective and pro-active investment monitoring?
      • Is position level reporting as useful as costs associated with it or the negative selection bias it can create?
      • Importance of relevant risk factors, value-at-risk analysis, stress tests, position concentration and “Greeks” that are unique to each fund strategy and sub-strategy
        • detail analysis without the disclosure of sensitive information
    • The role of pro-active forward looking qualitative monitoring should NOT be underestimated
    There are many views on the feasibility and importance of total transparency
  • 27. Post 1998 environment
    • How has the hedge fund industry changed since 1998?
      • Increased appreciation of dangers of excessive leverage and strategies that overly rely on it for profit (i.e. certain types of fixed income arbitrage trades)
        • there has been a large outflow of assets from hedge funds that use these approaches
      • Limitations of value-at-risk in event of major systemic shock (the ‘one in a hundred year’ scenario) and increased usefulness in stress testing portfolios
        • importance of understanding the shifting risks to both a single hedge fund manager and a portfolio during normal and shock market environments
    • Outcome has been a general decline in leverage across wide variety of strategies as evidenced by lower stress losses in 9/11
    • In addition, various global regulatory authorities are beginning to dedicate more time and resources to analyzing the hedge fund industry and their role within the financial markets
    Aftermath since LTCM
  • 28. Regulatory environment
    • Trading areas
      • Particular analysis is on relationship between research and trading within the sell side community and as it relates to hedge funds
      • Rules to restrict or increase the difficulty of short selling would have negative effect on hedge funds: not only are shorts alpha generating (bad companies with bad business models that are failing) but also are exposure reducing (like pair trading)
    • Non-trading areas
      • In the US, the source of funds (Patriot Act requirements)
      • SEC Hedge Fund Act Registration (as opposed to Regulation) is an important underpinning for investor confidence
    • Markets/countries that have placed restrictions on hedge fund activities have seen liquidity levels and traditional investor interest decline sharply
    Greater Oversight
  • 29. Industry maturation
    • Recent asset inflows into hedge funds have been strong
      • Nevertheless, hedge funds account for less than 6% of total market value of traditional long-only world of all financial assets
      • It is important to understand not just the absolute level of inflows but also to which strategies the inflows are going
        • large inflows currently going to strategies that need additional capital such as credit derivatives and other evolving new markets
    • Hedge fund performance is cyclical and profitable arbitrage situations ebb and flow
      • Certain strategies tend to be counter-cyclical to each other (like merger arbitrage and distressed credit), namely a diminished opportunity set in one strategy frequently leads to improving profit potential in the other
      • Hence, importance of a broad based portfolio to capture the changing opportunity sets of various strategies
    Is there a hedge fund bubble?
  • 30. Expectations and tolerances
    • Risk free interest rate + alpha + beta
      • Libor is a good proxy for the level of interest rates
      • Alpha is the ability to profit from either hedge fund manager selection (selection effect) and strategy allocation (allocation affect). These typically average around 6% net a year
      • Beta is the intended and unintended market movement of a portfolio. Since broad based fund of funds portfolios function as a diversifier, over time the beta can average around 0.20 to an index like the S&P 500
    Setting these before investing is important
  • 31. Expectations and tolerances (cont’d)
    • Given this equation, when fund of funds generated an annual return of 14% in the late 1990s, it was composed of an average Libor of 6%, 6% in alpha and 2% in beta (.20 beta * 10% average gain in the S&P 500)
    • In 2002 the performance for most fund of funds was 3%, with Libor at 2%, 6% in alpha and -5% beta (.20 beta * -25% loss in S&P)
    • All of this should be accomplished with an annualized volatility between 3% to 5%, a worse monthly loss between 1% to 2% and generating profitability 75% to 80% of all months
    Setting these before investing is important
  • 32. Allocation Issues
    • The decision to invest in hedge funds frequently comes down to two choices – invest directly or through a fund of fund
      • Investing directly avoids an additional layer of fees but introduces issues surrounding manager selection issues (access and return dispersion) and manager monitoring issues (disclosure and resources)
      • Investing in a fund of fund product avoids this issues but comes with an additional layer of fees
    • A common approach is to initially invest in a broad based fund of fund product then, over time and as experienced is gained, direct investments are made to multi-strategy single hedge funds
      • This model is frequently referred to as ‘core-satellite’, with the fund of funds representing the core 75% to 80% allocation while the satellite direct investments make up the balance
    • The ultimate decision is as unique as the individual plan sponsors business model and needs
  • 33. Conclusion
    • Broad based hedge fund portfolios belong in any investment portfolio due to the unique role they perform when combined with traditional asset classes
      • Non-correlated sources of alpha benefit any portfolio, and should always be incorporated, no matter what their source (hedge funds, real estate, private equity, timber etc)
    • Opportunities will continue to exist
      • The ability to perform regulatory arbitrage and lock up money is a key component in capturing alpha
      • Existing financial markets will inevitably grow in tandem with real economies and new strategies develop to exploit dislocations
    • Given these factors, the most logical question is not whether to invest or not but what are the appropriate allocation levels to make to a traditional portfolio
  • 34. Disclaimer Alternative Investment Solutions prepared the information, including but not limited the charts and graphs, contained within this presentation. Unless otherwise noted, the information used to create these charts and graphs was based solely on information collected and retained in Alternative Investment Solutions’ proprietary database and is accurate as of the date so indicated on the particular chart or graph. Third party funds and managers contributed to the majority of the information collected; therefore, Alternative Investment Solutions makes no representations as to the accuracy of such source information and the charts and graphs are subject to change without notice to the recipient. As such, the charts and graphs do not purport to be a scientific or academic analysis; but rather, represent some measure of support for the experientially based opinions of Alternative Investment Solutions. This document does not constitute an offer of securities. Such an offer will only be made by means of a confidential offering memorandum. This material is confidential and intended solely for the information of the person to whom it as been delivered. Recipients may not reproduce or transmit it, in whole or in part, to third parties. Past performance is not indicative of future results and future results may differ significantly from current or historical returns. This document has been issued through UBS O’Connor Limited for distribution to Intermediate or Market Counterparty customers and through UBS Global Asset Management (US) Inc. UBS O’Connor Limited (authorized and regulated by the Financial Services Authority in the UK) and UBS Global Asset Management (US) Inc. (a member of NASD and SIPC) are subsidiaries of UBS AG.
  • 35. Contact information Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object [Name] Tel: [+XX-XXX-XXX XXXX] [email@XXXX] A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A A ABC corp. A A Americas Roy Freeman* +1-203-719 5419 [email_address] Dan Murphy* +1-312-525 5133 [email_address] UK, Europe & Middle East (ex Switzerland) Tim Sweeting +44-20-7901 5835 [email_address] Rickard Fischerstrom +44-20-7901 5819 [email_address] Japan/Korea Yukio Nagamoto +81-3-5208 7657 [email_address] Akiko Ueno +81-3-5208 7405 [email_address] Switzerland René Steiner +41-1-239 33 35 [email_address] Asia Pacific Howard Knight +65-6836 5465 [email_address] Roger Tallboys +852-2971 8225 roger.tallboys@ubs.com Theresa Han +852-2971 8832 theresa.han@ubs.com Wealth Management Patrick Casparis (Europe) +41-1-239 18 96 [email_address] Elizabeth Sinn (Hong Kong) +852-2971 8806 [email_address] Elaine Zhao (Singapore)  +65-6836 5462 [email_address] Shelia Plaisance (Americas) +1-203-719 1506 [email_address] Enhanced Index Tiziana Holmgren +1-203-719 6223 [email_address] * Registered representatives of UBS Global Asset Management (US) Inc. Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object Layout Box: Select this box and use it to: Insert text - type text and apply a style Insert a Table or MS Graph Resize an object