1) The document discusses managing risk when investing in hedge funds and outlines minimum requirements for hedge funds to achieve "institutional quality". 2) It recommends evaluating hedge funds' ability to separate alpha and beta and produce positive expected returns before including them in a portfolio. 3) Hedge funds can be included either as an "alpha overlay" at the total portfolio level or through "portable alpha" in traditional asset classes to enhance returns while managing risk.

1. Managing Hedge Fund Risk The Quest for Institutional Quality 2005 Risk Management Conference Session Five: Risk-Aware Practices and Procedures, Part 2 August 24-26, 2005 Frederick E. Dopfel, Ph.D. Managing Director Barclays Global Investors

2. “Waiter, what’s that hedge fund doing in my soup? “ Well, sir, I think it’s the backstroke … ”

4. Hedge funds Growth in popularity “ What is the wind behind this sail? After all, hedge fund managers typically transact in asset markets similar to those used by traditional managers.” William Fung, London Business School & David Hsieh, Duke University

5. Performance 1994-2004 Compared to traditional asset classes Annualized risk Annualized returns Source: CSFB/Tremont, MSCI, Russell, S&P, and BGI estimates.Data based on monthly index returns from Jan ’94 to Jan ’04. Survivorship and mark-to-market biases? CSFB/Tremont Hedge Equity Mkt Neutral Managed Futures Long/Short Equity Global Macro Fixed Income Arb Risk Arbitrage Distressed Event Driven Emerging Markets Convertible Arbitrage Fund Index Russell 2000 S&P 500 Lehman Gov't Credit MSCI EAFE 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

6. Understanding Hedge Fund Exposures Separating alpha and beta Systematic Risk (beta) Expected return Stocks Bonds Any asset class r f  Hedge funds ?

7. Diversification with hedge funds? Warning! “ The diversification argument for hedge funds must be tempered by the lessons of the summer of 1998 when [the Russian default crisis] changed many of these correlations overnight from 0 to 1. In the physical or natural sciences, such phenomenon are examples of “phase-locking” behavior, situations in which otherwise uncorrelated actions suddenly become synchronized.” Andrew Lo, M.I.T.

9. Correlation in “down” markets Presence of short option strategies Source: CSFB/Tremont, MSCI, Russell, S&P, and BGI estimates. Data based on monthly index returns from Jan ’94 to Jan ’04. Correlation of CSFB/Tremont Hedge Fund Index and Russell 3000 Index Monthly Returns (1994-2004) Correlation = + 9% in “up” markets Correlation = + 56% in “down” markets

10. Hedge fund style? Warning! “ The fact that hedge funds are for the most part unregulated entities and the fact that there are no generally accepted standards for hedge fund style classification means that there are almost unlimited opportunities for individual funds to engage in strategic self misclassification .” William Goetzmann, Yale University and Stephen Brown, NYU

11. Asymmetric Beta Exposures Across hedge fund styles Asymmetric Hedge Fund Betas Realized Beta Estimates for Up and Down Markets Relative to Russell 300 Index based on Monthly Returns of CSFB/Tremont Hedge Fund Style Indexes, 1994-2004 Down Market Up Market

15. I. Hedge funds as “alpha overlay” at total plan level The efficient frontier and the active frontier contributed by hedge funds 0% 2% 4% 6% 8% 10% 0% Expected return 2% 4% 6% 8% 10% 12% 14% 16% 18% Risk Efficient frontier Active frontier Active “tail” extends above the efficient frontier active exposure policy

16. I. Hedge funds as “alpha overlay” at total plan level Impact of 10% Allocation to Hedge Fund Hedge Fund Assumptions (pure alpha) Return Risk Alpha Policy Beta Total Portfolio 7.5% 10.0% 0.75% 1.00% 6.50% 9.75% 7.25% 9.80% 9.80% 1.00% 9.75% Hedge fund alpha adds only incremental risk to the portfolio so long as “Institutional Quality” process is followed

17. II. Hedge funds in the asset class 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Expected active risk Expected alpha Small Value Active Small Growth Active Large Growth Active Large Value Active Large Cap Enhanced Small Cap Index Large Cap Index Current Holdings Active efficient frontier The active efficient frontier (blue) shows the highest possible expected alpha at a chosen level of active risk With skillful selection of hedge funds, the frontier can be dramatically enhanced (green) Hedge fund