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Hedge Funds: A Look Back and a Look Ahead
                                                 By Edward H. DeFrance and Michael J. Kelly


                                                                                                Synopsis
CRITICAL OBSERVATIONS:
                                                                                                Hedge funds have proven to be
• Including a group of broadly diversified hedge funds in a traditionally allocated portfolio   worthy financial instruments over
  of stocks and bonds has been shown to potentially reduce portfolio volatility and             the past 20 plus years, and have
  increase return.
                                                                                                contributed to the growth of the
• The investment environment for hedge funds going forward (2010 and beyond) could              modern financial industry. The
  be attractive. Investment strategies that can make money in rising and falling equity         addition of a well diversified group
  markets, such as those employed by many hedge funds, are better positioned for success
                                                                                                of hedge funds to a traditional
  in an uncertain/volatile economy.
                                                                                                portfolio has been shown to be an
• Hedge funds and the interests of their constituents are better aligned now than they
                                                                                                effective way to potentially increase
  were prior to 2008.
                                                                                                returns, while also preserving capital
• Due to the fallout of 2008 and the Bernie Madoff scandal, investors are assigning more
                                                                                                during adverse market environments.
  value to the strength and integrity of a firm’s risk controls and procedures when
  conducting due diligence on potential hedge fund investments, as opposed to focusing
                                                                                                While hedge funds have remained
  only on performance.                                                                          somewhat of a mystery to the general
                                                                                                public, and are often vilified by the
• Investors are seeking better transparency, better liquidity, and more appropriate fee
  structures from funds.                                                                        mainstream media (they were referred
                                                                                                to as an “evil virus” in a 2005 Newsweek
• Investors are requiring the use of independent, third-party services to support funds’
  operations, manage custody of their assets and verify fund pricing.
                                                                                                article for example), the reality is that
                                                                                                many institutions and high-net-worth
• Fund of hedge funds (FoHFs) will continue to be a major channel into hedge funds,
  providing more investors ease of access and exposure to a broad range of investment
                                                                                                investors have invested in hedge funds
  styles and strategies, along with an additional level of risk management.                     for many years, and continue to do so
                                                                                                as a means to add diversification to
                                                                                                their portfolios.
                                                                                                Going into 2010, the hedge fund
                                                                                                industry appears to be healthier than
                                                                                                it has been in more than a decade,
                                                                                                albeit much smaller in terms of
                                                                                                assets than it was at its peak two
years ago. While 2008 was without                                                              In 2009, investors are already starting
                                                                                                                           doubt one of the most challenging                                                              to reap the benefits of this new
                                                                                                                           investment environments we have                                                                hedge fund world order, as industry
                                                                                                                           seen this century, the hedge fund                                                              returns appear to be on pace to
                                                                                                                           industry emerged from the crisis                                                               reach 10-year highs. Looking ahead,
                                                                                                                           case-hardened and remains a viable                                                             reduced competition and major
                                                                                                                           compliment to traditional stock and                                                            macroeconomic trends could lead to
                                                                                                                           bond investing. From an investment                                                             above average returns.
                                                                                                                           opportunity standpoint, the landscape
                                                                                                                           is attractive as many asset classes are                                                        A History of Success …
                                                                                                                           offering substantial risk premiums                                                             and Misunderstanding?
                                                                                                                           and competition has significantly                                                              “It is the nature of humans to
                                                                                                                           diminished (with weaker, less-                                                                  fear what it is they do not know
                                                                                                                           qualified hedge funds closing in 2008,                                                          or understand.”
                                                                                                                           fewer asset managers are chasing                                                                   ~ Rod Serling, creator of
                                                                                                                           similar trades – leaving more pie for                                                                The Twilight Zone
                                                                                                                           the worthy survivors to share).
                                                                                                                                                                                                                          Clearly, hedge funds have played an
                                                                                                                           For investors, the most tangible                                                               important part in the expansion of
                                                                                                                           positive outcome left by the shock of                                                          capital markets in recent years. Since
                                                                                                                           2008 has been a humbling of sorts for                                                          1990, hedge funds have represented
                                                                                                                           the industry. Many previously closed                                                           one of the fastest growing segments
                                                                                                                           hedge funds have now opened their                                                              of asset management. The number
                                                                                                                           doors to accept new capital, are much                                                          of hedge funds around the world
                                                                                                                           more willing to be flexible on fees and                                                        exploded from 610 in 1990 to
                                                                                                                           lock-up periods, and – perhaps most                                                            approximately 9,000 by the end
                                                                                                                           significantly – are much more willing                                                          of 2008.1 Over the same period,
                                                                                                                           to pull back the curtain and share                                                             industry assets under management
                                                                                                                           information about their success.                                                               grew exponentially as well, from
                                                                                                                                                                                                                          $39 billion to an all-time high of
               GRAPH 1:                                                                                                                                                                                                   $1.9 trillion by the second quarter
               Total Hedge Fund Assets                                                                                                                                                                                    of 20082 (Graph 1).
                                                                                December 1990 through June 2009 Estimate                                                                                                  For something that has grown so
                                                $2,100
                                                                                                                                                                                          $1,868
                                                                                                                                                                                                                          rapidly and become such an integral
                                                                                                                                                                                                                          part of the global financial system
                                                $1,600
                Hedge Fund Assets ($ billion)




                                                                                                                                                                                 $1465
                                                                                                                                                                                                   $1407                  through the years, there is still a
                                                $1,100                                                                                                           $973
                                                                                                                                                                         $1105
                                                                                                                                                                                                            $1000
                                                                                                                                                                                                                          general lack of understanding about
                                                                                                                                                         $820                                                             the hedge fund industry. Indeed, it
                                                                                                                                                 $626
                                                 $600
                                                                                                                           $456 $491
                                                                                                                                     $539                                                                                 is often surprising to those of us who
                                                                                                            $368 $375
                                                                              $168 $167 $186
                                                                                                    $257
                                                                                                                                                                                                                          work in the industry just how much
                                                 $100           $58    $96
                                                         $39
                                                                                                                                                                                                                          misinformation is circulated, not
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                                                                                                                                                                                                     2008

                                                                                                                                                                                                              Jun 09




                                                $(400)
                                                                                                                                                                                                                          just among small investors, but even
               Source: HFR Global Hedge Fund Industry Report, second quarter 2009. Hedge Fund Research, Inc.,
                                                                                                                                                                                                                          at the highest levels of sophisticated
               August 2009, www.hedge-fundresearch.com                                                                                                                                                                    institutional asset management.
             240%



             190%
                                                                                                                                                                                                                       Bonds
                                                                                                                                                                   -2-                                                 Hedge Funds
ive Return




             140%                                                                                                                                                                                                      Stocks
The confusion, and in some cases                                                                                                          “Absolute” Returns
                    Hedge Funds: A Primer                                                                                                                                        controversy, over hedge funds is                                                                                                          By design, most hedge funds are
                    What is a hedge fund?                                                                                                                                        likely a function of their private                                                                                                        intended to provide consistent
                    •	 	 he	term	‘hedge	fund’	refers	to	
                       T                                                                                                                                                         structure. As opposed to a mutual                                                                                                         positive returns regardless of the
                       pooled	investment	structures                                                                                                                              fund, almost all hedge funds are                                                                                                          direction of the broad markets,
                    •	 	 edge	funds	may	utilize	a	broad	
                       H                                                                                                                                                         private offerings because they are not                                                                                                    utilizing a wide variety of financial
                       array	of	financial	instruments	to	                                                                                                                        sold publicly on open exchanges.
                                                                                                                                                                                                                                                                                                                           instruments to do so. This approach
                       generate	performance                                                                                                                                      Because of this, the Securities and
                                                                                                                                                                                                                                                                                                                           stands in contrast to that of traditional
                    •	 	 here	are	many	types	of	hedge	
                       T                                                                                                                                                         Exchange Commission strictly limits
                                                                                                                                                                                                                                                                                                                           managers, who measure themselves
                       funds	using	many	different	                                                                                                                               the amount of information that
                                                                                                                                                                                                                                                                                                                           in relative terms and are prepared to
                       investment	strategies                                                                                                                                     can be shared about them with the
                                                                                                                                                                                                                                                                                                                           accept losses in value, if those losses
                    •	 	 ension	funds,	endowments,	
                       P                                                                                                                                                         general public.
                       insurance	companies,	private	banks,	
                                                                                                                                                                                                                                                                                                                           are less than a stated benchmark
                       and	high-net	worth	individuals	and	
                                                                                                                                                                                  As such, many investors consider                                                                                                         (such as the S&P 500 Index).
                       families	invest	in	hedge	funds                                                                                                                             hedge funds highly risky, highly
                                                                                                                                                                                                                                                         Hedge funds have, for the most part,
                                                                                                                                                                                  aggressive and somewhat speculative
                    •	 	 any	hedge	funds	attempt	to	achieve	
                       M                                                                                                                                                                                                                                 succeeded in achieving this goal
                       positive	returns	in	both	rising	and	                                                                                                                       investments. Sensationalized hedge
                                                                                                                                                                                                                                                         and in preserving capital during bear
                       falling	capital	market	environments                                                                                                                        fund blow-ups and frauds, like Long
                                                                                                                                                                                                                                                         markets. From 1990 to 2008, the
                    •	 	 he	inclusion	of	hedge	funds	in	a	
                       T                                                                                                                                                          Term Capital Management or the
                                                                                                                                                                                                                                                         industry experienced only two down
                       traditional	portfolio	is	intended	to	                                                                                                                      Madoff scandal (see page 5) naturally
                                                                                                                                                                                                                                                         years, weathering difficult periods
                       add	diversification,	reduce	risk	and	                                                                                                                      contribute to this misconception.
                                                                                                                                                                                                                                                         like the Mexican peso crisis, the
                       potentially	increase	returns                                                                                                                               While in some cases this is true, the
                                                                                                                                                                                                                                                         Asian financial crisis, the collapse of
                    •	 	 edge	funds	seek	to	maintain	low	
                       H                                                                                                                                                          reality is that there are a wide variety
                       correlations	(definition	on	page	4)	                                                                                                                       of different types of hedge funds,                                     Long Term Capital Management, the
                       with	traditional	assets	classes	(stocks	                                                                                                                   each utilizing different levels of risk                                bursting of the dot-com bubble, and
                       and	bonds)
                                                                                                                                                                                  and each seeking different types of                                    the collapse of the credit markets in
                    •	 	 ost	hedge	funds	do	not	measure	
                       M
                                                                                                                                                            $2,100
                                                                                                                                                                                  returns. Many hedge funds actually                                     2001-2002. From a performance
                                                                                                                                                                                                                                                                               $1,868
                            $2,100
                       themselves	against	traditional	market	
                                                         $1,600                                                                                                                   pursue very conservative strategies
                                                                                                                                                                                                                                 $1,868                  perspective, hedge funds have been
                                                                                                                            Hedge Fund Assets ($ billion)




                                                                                                                                                                                                                                                                         $1465
                       benchmarks	(like	the	S&P	500	Index)	
                            $1,600
                                                                                                                                                                                  that target modest but consistent                                      successful in achieving their objective
                                                                                                                                                                                                                                                                                      $1407
                        Hedge Fund Assets ($ billion)




                                                                                                                                                                                                                           $1465
                       but	instead	target	“absolute”	returns	                                                                                                                                                                           $1407
                                                                                                                                                                                                                                                         of providing consistent returns that
                                                                                                                                                                                                                                                                   $1105
                                                         $1,100
                       (positive	performance	regardless	of	                                                                                                                       returns and – above all – relatively
                                                                                                                                                                                                                     $1105
                                                                                                                                                                                                                                                              $973                          $1000
                            $1,100
                                                                                                                                                                                  low risk.
                                                                                                                                                                                                               $973                           $1000
                                                                                                                                                                                                                                                         exhibit low correlation to the broad
                                                                                                                                                                                                                                                         $820

                       the	direction	of	the	broad	markets)	                                                                                                                                              $820                                       $626
                                                          $600
                                                         $600                                                                                                                                  $539
                                                                                                                                                                                                    $626
                                                                                                                                                                                                                    $368 $375
                                                                                                                                                                                                                                 $456 $491
                                                                                                                                                                                                                                               $539
                                                                                                                                                                                                                                                         equity markets, while maintaining
                                                                                                                                                                                     $456 $491
                                                                                                              $257
                                                                                                                                                                     $368       $375
                                                                                                                                                                                   $58 $96
                                                                                                                                                                                             $168 $167 $186
                                                                                                                                                                                                              $257
                                                                                                                                                                                                                                                         low volatility (Graph 2).
                                                                                               $168 $167 $186 $100
GRAPH 2:
      $100                                                         $39          $58     $96
                                                                                                                                                                        $39
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Hedge Funds at Work – Providing Consistent Returns
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                            $(400)
      $(400)
                                                                            Cumulative Return and Value of $1 Million Investment
                                                                               October 1994 through September 2009
                                                                                                                     240%
                     240%



                     190%                                                                                            190%                                                                                     Bonds:	$1.91	million
                                                                                                                                                                                                                                                                                                                   BondsBonds:	$2.78	million                                    Bonds
                                                                                                                                                                                                              Hedge	Funds:	
                                                                                                                                                                                                                                                                                                                   Hedge Funds
                                                                                                                                                                                                                                                                                                                        Hedge	Funds:	$2.52	million                              Hedge Funds
                                                                                                                                                                                                              $1.84	million
                                                                                                 Cumulative Return
Cumulative Return




                     140%                                                                                            140%                                                                                                                                                                                          Stocks                                                       Stocks
                                                                                                                                                                                                                                                                                                                           Stocks:	$2.29	million


                      90%                                                                                                90%

                                                                                                                                                                                                                                                                                                                           All data is sourced from Pertrac. Hedge funds are
                      40%                                                                                                                                                                                                                                                                                                  represented by the Edhec Fund of Hedge Funds Index.
                                                                                                                         40%
                                                                                                                                                                                                             Stocks:	$1.31	million                                                                                         Global equities are represented by the MSCI World
                                                                                                                                                                                                                                                                                                                           Equity Index. Bonds are represented by the Barclays
                     -10%                                                                                                                                                                                                                                                                                                  US Corp. IG Index. Please see page 11 for additional
                                                                                                                     -10%
                                                                                                                                                                                                                                                                                                                           information on data sources.
                               4

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                                                                   14%
                                                                                                                                                                       14%                                                      -3-
                                                                                                                                                                                                                Risk reduced by 28%
                                                                   12%                                       11.6%                                                                                                                                                                                  Risk reduced by 28%
                                                                                                                                                                       12%                                                 11.6%                       Return Increased
                                                                   10%                                                                                                                                                                                      by 3%                                                             Return Increased
Going Mainstream                                                                                           recently demonstrated an ability to
                                                                                                                                                            Demonstrating success during the                                                                           add value to a traditional portfolio
                                                                                                                                                            2000-2002 bear market, hedge                                                                               allocation, by both enhancing returns
                                                                                                                                                            funds essentially signaled their arrival                                                                   and reducing risk (see Graph 3).
                                                                                                                                                            to the world. What had been until
                                                                                                                                                                                                                                                                       Growth and Consequences
                                                                                                                                                            then a vehicle that only the most
                                 $2,100
                                             Correlation is a statistical measure of                                                                        sophisticated and ultra-high-net-          As a by-product of this surge in
                                             how two securities move in relation to                                                                                                                    investor appetite, industry assets
                                                                                                                                                            worth investors were privy to – or
                                                                                                                                                                                            $1,868

                                             each other. Perfect positive correlation
                                 $1,600                                                                                                                     interested in, for that matter – hedge     under management grew
 Hedge Fund Assets ($ billion)




                                             implies that as one security moves,                                                                                                      $1465
                                                                                                                                                                                                   $1407
                                             either up or down, the other security                                                                          funds began garnering attention from       substantially. From 2000 to 2008,
                                                                                                                                                                                $1105
                                 $1,100
                                             will move in lockstep, in the same                                                                             other parts of the investor spectrum,
                                                                                                                                                                           $973                        hedge fund assets expanded 20%
                                                                                                                                                                                                         $1000

                                             direction. Alternatively, perfect negative                                                                     most $626
                                                                                                                                                                      $820
                                                                                                                                                                   notably institutions and other      per year,3 growing nearly four times
                                   $600      correlation means that if one security                                                           $456          wealthy investors.
                                                                                                                                                         $491 $539                                     in size since 2000.4 There were some
                                                                                  $368 $375
                                             moves in either direction the $257
                                                                             security                                                                                                                  negative consequences of this
                                   $100
                                                             $168 $167 $186
                                             that is$58 $96 negatively correlated
                                                     perfectly                                                                                              Institutions began seeking them out
                                              $39
                                                                                                                                                                                                       exponential growth: transparency
                                             will move by an equal amount in the                                                                            much more frequently as a source
                                                                                                                                                                                                       levels were not satisfactory, as
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                                                                                                                                                                                                                                                              Jun 09
                                  $(400)     opposite direction. If the correlation is 0,                                                                   of diversification and “absolute”
                                                                                                                                                                                                       investors often acquiesced to
                                             the movements of the securities are                                                                            performance following on the stable
                                             said to have no correlation; they are                                                                                                                     manager’s preferences for secrecy;
                                                                                                                                                            returns hedge funds had demon-
%                                            completely random.                                                                                                                                        due diligence standards were often
                                                                                                                                                            strated during the dot-com bust.
                                                                                                                                                                                                       compromised (as was clearly the
                                                                                                                                                            Sustained low interest rates during
%                                                                                                                                                                                                      case for some feeder funds directing
                                                                                                                                                            this period, coupled with a flat    Bonds
                                                                                                                                                                                                Hedge their clients to Madoff); and poor
                                                                                                                                                            equity environment, also contributed Funds
                                                                                                                                                                                                Stocks liquidity management practices
%
                                                                                                                                                            to this interest. From a performance
                                                                                                                                                                                                       emerged, high-lighted by the high
                                                                                                                                                            perspective, a broadly diversified
                                                                                                                                                                                                       number of funds who gated their
%
                                                                                                                                                            portfolio of hedge funds has fairly
                                                                                                                                                                                                       investors in 2008.
%                                                                                                                                                                                                                                                                      Extreme growth also diluted the
                                             GRAPH 3:
                                                                                                                                                                                                                                                                       quality and skill of fund managers.
%                                            Hedge Funds at Work – Benefits to Traditional Portfolio                                                                                                                                                                   Previously, hedge fund managers had
                                                                                                                                                                                                                                                                       been Wall Street’s best and brightest.
        4

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                                                                  Impact on Risk and Return – October 1994 through September 2009
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                                             14%
                                                                                                                                                                                                                                                                       However by late 2006, anyone with a
                                                                                   11.6%
                                                                                                                                                             Risk reduced by 28%                                                                                       financial calculator suddenly believed
                                             12%
                                                                                                                                                                                                   Return Increased                                                    he or she was qualified to do the job.
                                             10%                                                                                                                                                        by 3%
                                                                                                                                                                           8.3%
                                                                                   Annualized Volatility




                                                8%
                                                                                                                       6.4%                                                                                      6.6%
                                                                                                                                                                           Annualized Volatility
                                                                                          (Risk)




                                                6%
                                                                                                                                                                                  (Risk)
                                                                                                                       Annualized




                                                                                                                                                                                                                 Annualized




                                                4%
                                                                                                                         Return




                                                                                                                                                                                                                   Return




                                                2%

                                                0%
                                                                                     Traditional Portfolio                                                         Traditional Portfolio with Hedge Funds
                                                                                   (70% stocks, 30% bonds)                                                       (40% stocks, 30% bonds, 30% hedge funds)




                                             Volatility is measured by standard deviation. Standard deviation is a measure of the dispersion versus
                                             the mean or experienced value: the higher the standard deviation, the greater the volatility. Please see
                                             page 11 for additional information on data sources.



                                                                                                                                                                                                                       -4-
Hedge Funds: A Look Back at Industry Changes and Future Outlook
Hedge Funds: A Look Back at Industry Changes and Future Outlook
Hedge Funds: A Look Back at Industry Changes and Future Outlook
Hedge Funds: A Look Back at Industry Changes and Future Outlook
Hedge Funds: A Look Back at Industry Changes and Future Outlook
Hedge Funds: A Look Back at Industry Changes and Future Outlook
Hedge Funds: A Look Back at Industry Changes and Future Outlook
Hedge Funds: A Look Back at Industry Changes and Future Outlook

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Hedge Funds: A Look Back at Industry Changes and Future Outlook

  • 1. Hedge Funds: A Look Back and a Look Ahead By Edward H. DeFrance and Michael J. Kelly Synopsis CRITICAL OBSERVATIONS: Hedge funds have proven to be • Including a group of broadly diversified hedge funds in a traditionally allocated portfolio worthy financial instruments over of stocks and bonds has been shown to potentially reduce portfolio volatility and the past 20 plus years, and have increase return. contributed to the growth of the • The investment environment for hedge funds going forward (2010 and beyond) could modern financial industry. The be attractive. Investment strategies that can make money in rising and falling equity addition of a well diversified group markets, such as those employed by many hedge funds, are better positioned for success of hedge funds to a traditional in an uncertain/volatile economy. portfolio has been shown to be an • Hedge funds and the interests of their constituents are better aligned now than they effective way to potentially increase were prior to 2008. returns, while also preserving capital • Due to the fallout of 2008 and the Bernie Madoff scandal, investors are assigning more during adverse market environments. value to the strength and integrity of a firm’s risk controls and procedures when conducting due diligence on potential hedge fund investments, as opposed to focusing While hedge funds have remained only on performance. somewhat of a mystery to the general public, and are often vilified by the • Investors are seeking better transparency, better liquidity, and more appropriate fee structures from funds. mainstream media (they were referred to as an “evil virus” in a 2005 Newsweek • Investors are requiring the use of independent, third-party services to support funds’ operations, manage custody of their assets and verify fund pricing. article for example), the reality is that many institutions and high-net-worth • Fund of hedge funds (FoHFs) will continue to be a major channel into hedge funds, providing more investors ease of access and exposure to a broad range of investment investors have invested in hedge funds styles and strategies, along with an additional level of risk management. for many years, and continue to do so as a means to add diversification to their portfolios. Going into 2010, the hedge fund industry appears to be healthier than it has been in more than a decade, albeit much smaller in terms of assets than it was at its peak two
  • 2. years ago. While 2008 was without In 2009, investors are already starting doubt one of the most challenging to reap the benefits of this new investment environments we have hedge fund world order, as industry seen this century, the hedge fund returns appear to be on pace to industry emerged from the crisis reach 10-year highs. Looking ahead, case-hardened and remains a viable reduced competition and major compliment to traditional stock and macroeconomic trends could lead to bond investing. From an investment above average returns. opportunity standpoint, the landscape is attractive as many asset classes are A History of Success … offering substantial risk premiums and Misunderstanding? and competition has significantly “It is the nature of humans to diminished (with weaker, less- fear what it is they do not know qualified hedge funds closing in 2008, or understand.” fewer asset managers are chasing ~ Rod Serling, creator of similar trades – leaving more pie for The Twilight Zone the worthy survivors to share). Clearly, hedge funds have played an For investors, the most tangible important part in the expansion of positive outcome left by the shock of capital markets in recent years. Since 2008 has been a humbling of sorts for 1990, hedge funds have represented the industry. Many previously closed one of the fastest growing segments hedge funds have now opened their of asset management. The number doors to accept new capital, are much of hedge funds around the world more willing to be flexible on fees and exploded from 610 in 1990 to lock-up periods, and – perhaps most approximately 9,000 by the end significantly – are much more willing of 2008.1 Over the same period, to pull back the curtain and share industry assets under management information about their success. grew exponentially as well, from $39 billion to an all-time high of GRAPH 1: $1.9 trillion by the second quarter Total Hedge Fund Assets of 20082 (Graph 1). December 1990 through June 2009 Estimate For something that has grown so $2,100 $1,868 rapidly and become such an integral part of the global financial system $1,600 Hedge Fund Assets ($ billion) $1465 $1407 through the years, there is still a $1,100 $973 $1105 $1000 general lack of understanding about $820 the hedge fund industry. Indeed, it $626 $600 $456 $491 $539 is often surprising to those of us who $368 $375 $168 $167 $186 $257 work in the industry just how much $100 $58 $96 $39 misinformation is circulated, not 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) just among small investors, but even Source: HFR Global Hedge Fund Industry Report, second quarter 2009. Hedge Fund Research, Inc., at the highest levels of sophisticated August 2009, www.hedge-fundresearch.com institutional asset management. 240% 190% Bonds -2- Hedge Funds ive Return 140% Stocks
  • 3. The confusion, and in some cases “Absolute” Returns Hedge Funds: A Primer controversy, over hedge funds is By design, most hedge funds are What is a hedge fund? likely a function of their private intended to provide consistent • he term ‘hedge fund’ refers to T structure. As opposed to a mutual positive returns regardless of the pooled investment structures fund, almost all hedge funds are direction of the broad markets, • edge funds may utilize a broad H private offerings because they are not utilizing a wide variety of financial array of financial instruments to sold publicly on open exchanges. instruments to do so. This approach generate performance Because of this, the Securities and stands in contrast to that of traditional • here are many types of hedge T Exchange Commission strictly limits managers, who measure themselves funds using many different the amount of information that in relative terms and are prepared to investment strategies can be shared about them with the accept losses in value, if those losses • ension funds, endowments, P general public. insurance companies, private banks, are less than a stated benchmark and high-net worth individuals and As such, many investors consider (such as the S&P 500 Index). families invest in hedge funds hedge funds highly risky, highly Hedge funds have, for the most part, aggressive and somewhat speculative • any hedge funds attempt to achieve M succeeded in achieving this goal positive returns in both rising and investments. Sensationalized hedge and in preserving capital during bear falling capital market environments fund blow-ups and frauds, like Long markets. From 1990 to 2008, the • he inclusion of hedge funds in a T Term Capital Management or the industry experienced only two down traditional portfolio is intended to Madoff scandal (see page 5) naturally years, weathering difficult periods add diversification, reduce risk and contribute to this misconception. like the Mexican peso crisis, the potentially increase returns While in some cases this is true, the Asian financial crisis, the collapse of • edge funds seek to maintain low H reality is that there are a wide variety correlations (definition on page 4) of different types of hedge funds, Long Term Capital Management, the with traditional assets classes (stocks each utilizing different levels of risk bursting of the dot-com bubble, and and bonds) and each seeking different types of the collapse of the credit markets in • ost hedge funds do not measure M $2,100 returns. Many hedge funds actually 2001-2002. From a performance $1,868 $2,100 themselves against traditional market $1,600 pursue very conservative strategies $1,868 perspective, hedge funds have been Hedge Fund Assets ($ billion) $1465 benchmarks (like the S&P 500 Index) $1,600 that target modest but consistent successful in achieving their objective $1407 Hedge Fund Assets ($ billion) $1465 but instead target “absolute” returns $1407 of providing consistent returns that $1105 $1,100 (positive performance regardless of returns and – above all – relatively $1105 $973 $1000 $1,100 low risk. $973 $1000 exhibit low correlation to the broad $820 the direction of the broad markets) $820 $626 $600 $600 $539 $626 $368 $375 $456 $491 $539 equity markets, while maintaining $456 $491 $257 $368 $375 $58 $96 $168 $167 $186 $257 low volatility (Graph 2). $168 $167 $186 $100 GRAPH 2: $100 $39 $58 $96 $39 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 Hedge Funds at Work – Providing Consistent Returns 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) $(400) Cumulative Return and Value of $1 Million Investment October 1994 through September 2009 240% 240% 190% 190% Bonds: $1.91 million BondsBonds: $2.78 million Bonds Hedge Funds: Hedge Funds Hedge Funds: $2.52 million Hedge Funds $1.84 million Cumulative Return Cumulative Return 140% 140% Stocks Stocks Stocks: $2.29 million 90% 90% All data is sourced from Pertrac. Hedge funds are 40% represented by the Edhec Fund of Hedge Funds Index. 40% Stocks: $1.31 million Global equities are represented by the MSCI World Equity Index. Bonds are represented by the Barclays -10% US Corp. IG Index. Please see page 11 for additional -10% information on data sources. 4 95 96 6 97 98 8 99 4 0 95 0 96 1 t 9 02 n 02 b 03 t9 4 4 Fe n 05 Oc 06 06 07 08 08 09 t9 t9 t9 t9b0 n t0 b 0 Oc b 0 Ju c t 0 n b n b n Fe Jun Oc Feb Ju O c t Fe un b ct 01n b 02t 03n 6 J7 Fe8 O8 J99 Fe0 00 0e2 04 4 05 06 6 07 08 8 09 Oc Oc Oc Ju O c t Oc Ju Ju Ju u u n Ju Fe Fe Oc Fe 9 9 0 tO t0 t0 t0 bF nJ n b b n b n b n Oc Oc Oc Oc Ju Ju Ju Ju Ju Fe Fe Fe Fe 14% 14% -3- Risk reduced by 28% 12% 11.6% Risk reduced by 28% 12% 11.6% Return Increased 10% by 3% Return Increased
  • 4. Going Mainstream recently demonstrated an ability to Demonstrating success during the add value to a traditional portfolio 2000-2002 bear market, hedge allocation, by both enhancing returns funds essentially signaled their arrival and reducing risk (see Graph 3). to the world. What had been until Growth and Consequences then a vehicle that only the most $2,100 Correlation is a statistical measure of sophisticated and ultra-high-net- As a by-product of this surge in how two securities move in relation to investor appetite, industry assets worth investors were privy to – or $1,868 each other. Perfect positive correlation $1,600 interested in, for that matter – hedge under management grew Hedge Fund Assets ($ billion) implies that as one security moves, $1465 $1407 either up or down, the other security funds began garnering attention from substantially. From 2000 to 2008, $1105 $1,100 will move in lockstep, in the same other parts of the investor spectrum, $973 hedge fund assets expanded 20% $1000 direction. Alternatively, perfect negative most $626 $820 notably institutions and other per year,3 growing nearly four times $600 correlation means that if one security $456 wealthy investors. $491 $539 in size since 2000.4 There were some $368 $375 moves in either direction the $257 security negative consequences of this $100 $168 $167 $186 that is$58 $96 negatively correlated perfectly Institutions began seeking them out $39 exponential growth: transparency will move by an equal amount in the much more frequently as a source levels were not satisfactory, as 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) opposite direction. If the correlation is 0, of diversification and “absolute” investors often acquiesced to the movements of the securities are performance following on the stable said to have no correlation; they are  manager’s preferences for secrecy; returns hedge funds had demon- % completely random. due diligence standards were often strated during the dot-com bust. compromised (as was clearly the Sustained low interest rates during % case for some feeder funds directing this period, coupled with a flat Bonds Hedge their clients to Madoff); and poor equity environment, also contributed Funds Stocks liquidity management practices % to this interest. From a performance emerged, high-lighted by the high perspective, a broadly diversified number of funds who gated their % portfolio of hedge funds has fairly investors in 2008. % Extreme growth also diluted the GRAPH 3: quality and skill of fund managers. % Hedge Funds at Work – Benefits to Traditional Portfolio Previously, hedge fund managers had been Wall Street’s best and brightest. 4 95 96 6 97 98 8 99 00 0 01 02 2 03 04 4 05 06 6 07 08 8 09 t9 t9 t9 t0 t0 t0 t0 t0 Impact on Risk and Return – October 1994 through September 2009 n b n b n b n b n b n b n b n Oc Oc Oc Oc Oc Oc Oc Oc Ju Ju Ju Ju Ju Ju Ju Ju Fe Fe Fe Fe Fe Fe Fe 14% However by late 2006, anyone with a 11.6% Risk reduced by 28% financial calculator suddenly believed 12% Return Increased he or she was qualified to do the job. 10% by 3% 8.3% Annualized Volatility 8% 6.4% 6.6% Annualized Volatility (Risk) 6% (Risk) Annualized Annualized 4% Return Return 2% 0% Traditional Portfolio Traditional Portfolio with Hedge Funds (70% stocks, 30% bonds) (40% stocks, 30% bonds, 30% hedge funds) Volatility is measured by standard deviation. Standard deviation is a measure of the dispersion versus the mean or experienced value: the higher the standard deviation, the greater the volatility. Please see page 11 for additional information on data sources. -4-