1 the benefits of hedge funds the first seoul international derivatives securities conference thomas...

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The Benefits of Hedge Funds

The First Seoul International Derivatives Securities Conference

Thomas Schneeweis & Vassilis KaravasAugust 28, 2003

CISDM/UMASS-Amherst 2

Outline

I. Introduction to Traditional and Alternative

Investments

II. Benefits of Hedge Fund Investment

III. Hedge Funds in Asset Allocation


I. Introduction to Traditional and Alternative Investments

What Are Hedge Funds?

Hedge Fund Facts

Academic Evidence on Traditional Investment Performance

Academic Evidence on Hedge Fund Performance


Introduction to Traditional & Alternative Investments

Investment Alternatives

Traditional Alternatives Modern Alternatives Traditional Investments

Private EquityCommoditiesReal Estate

Hedge FundsManaged Futures

StocksBonds


What is a Hedge Fund?

Term “Hedge Fund” is a misnomer with little descriptive power 1950’s: A.W. Jones Model

-Long/Short U.S. equities-Capture two opportunity sets while reducing overall market exposure-“Hedge Fund” term accurately reflected the underlying strategy

2000’s: Generic reference to a private, commingled vehicle investing in marketable securities

-Strategy characteristics vary widely-Markets in which they participate vary widely-Risk/return characteristics vary widely-Common organizational and structural characteristics


What are Hedge Funds?

Various Definitions

A multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction.

A loosely regulated private pooled investment vehicle that can invest in both cash and derivative markets on a leveraged basis for the benefits of its investors.

A hedge fund is a private investment portfolio, usually structured as a limited partnership, open to accredited investors, charging an incentive based fee, and managed by a general partner with every financial tool imaginable at his disposal.


Hedge Fund Classifications

Relative Value Market Neutral Equity (Long undervalued/short overvalued stock) Convertible Hedging (Long convertible. bonds/short stock) Bond hedging (Yield curve arbitrage)

Event Driven Corporate transactions and special situations Deal Arbitrage (Long/short equity involved in corporate transactions) Bankruptcy/Distressed (Long securities involved in financial distress) Multi-strategy (Deal arbitrage and bankruptcy)

Equity Hedge Funds Domestic Long (Long undervalued US equities) Domestic Opportunity (Long/Short Equity (long bias))

Global Asset Allocators/Global Macro Systematic (trend-following or other quantitative analysis) Discretionary (Long or short markets based on fundamental analysis)

Short Sellers


Hedge Fund Facts

Hedge funds are not riskier than traditional stock and bond investments

Not all hedge funds are highly levered

Most hedge funds trade in liquid and transparent markets

Hedge fund strategies have existed for decades

Hedge funds are not absolute return investments (e.g., make money in all markets) but do offer unique risk and return opportunities not available in traditional stock and bond markets.


Academic Evidence on Traditional Asset Investment Performance

Actively managed stocks and bond portfolios provide little alpha (excess return relative to benchmarks)

With increased globalization, stock and bond investment provide limited diversification


Little Evidence of Equity Fund Alpha (1996-2002)

Return Comparison of Lipper and S&P Indices

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

Lipper

LipperLipper

LipperLipper

Lipper

S&P S&P

S&P

S&P

S&PS&P


Little Evidence of Diversification Benefits Across Stock Markets (1990-2002)

Ranked Equity Returns on S&P 500 (1990-2002)

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

1 2 3 4 5 6 7 8 9 10 11 12

Ranked ReturnsAve

rage

Mon

thly

Ret

urns

S&P 500 T otal Return MSCI WorldMSCI N. Amer. MSCI EuropeMSCI Pacific MSCI Far East


Academic Evidence on Hedge Funds

Hedge funds and CTAs offer the potential for alpha (excess return relative to common benchmarks such as equal risk S&P 500 or Lehman Bond Indices)

Hedge funds and CTAs offer the potential for diversification to existing stock or bond portfolios

Multi-factor models which describe return process for stocks and bonds also describe the return process for hedge funds

Modern methods of asset allocation used to deliver desired risk and return tradeoff for stocks or bonds can also be used for hedge funds


Evidence of Hedge Funds in Providing Diversification Benefits Relative to Stocks and Bonds (1990-2002)

Dive rs ification Be nefits Ranked on Lehman US Aggre gate 1990-2002

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

1 2 3 4 5 6 7 8 9 10 11 12

Ranked Portfolios

Ave

rage

Mon

thly

Ret

urns

S&P 500 Total Return Index Lehman U.S. AggregateLehman Global Aggregate EACM 100


II. Benefits of Hedge Funds

Why Hedge Funds?

Source of Hedge Fund Benefits

Analysis of Hedge Fund Returns


Hedge funds represent a large and growing industry that offers investors an opportunity to diversify and to earn competitive returns with low to moderate volatility.

Annualized Return and Standard Deviation (1996-2002)

CISDM $ Weighted CTA Index

Lehman US AggregateS&P 500

EACM 100

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Annual Return Standard Deviation

Correlation of EACM 100 With Other Indices (1996-2002)

CISDM $ Weighted CTA Index

Lehman US Aggregate

S&P 500

0.00

0.10

0.20

0.30

0.40

0.50

0.60

Why Hedge Funds?


Source of Hedge Fund Benefits

Unique Return Opportunities Strategy based Manager based

Unique Diversification Opportunities (use wider range of instruments

Different sources of return (long and short investing, concentrated asset positions)


Hedge Fund Performance Indices

Active manager based peer indices (similar to Morningstar or Lipper Mutual Fund Indices)

EACMCSFB/TremontHFRCISDMMSCIS&PZurich

Note: Academic research has shown that use of different indices may show different levels of risk and return benefits but basic conclusions are the same regardless of performance index used.


PerformanceEACM 100 S&P 500 Lehman Gov./Corp. MSCI Lehman

January 1990-December 2002 Bond Global Bond

Annualized Return 12.83% 9.68% 8.30% 4.20% 7.65%Annualized Standard Deviation 4.28% 15.28% 4.25% 15.08% 5.03%Sharpe Ratio 1.88 0.32 0.83 -0.04 0.57Minimum Monthly Return -4.45% -14.46% -2.45% -13.35% -2.97%Correlation With EACM 100 0.41 0.15 0.41 0.04

Portfolio I Portfolio II Portfolio III Portfolio IVS&P 500 & S&P 500, Lehman Bond MSCI and MSCI, Lehman Global Bond

Lehman Bond and EACM 100 Lehman Global Bond and EACM 100

Annualized Return 9.30% 10.05% 6.21% 7.55%Annualized Standard Deviation 8.25% 7.00% 8.43% 7.11%Sharpe Ratio 0.55 0.75 0.17 0.39Minimum Monthly Return -6.25% -5.89% -5.63% -5.39%Correlation with EACM 100 0.42 0.37

Portfolio I = 50% S&P 500 and 50% Lehman Brothers Gov./Corp. BondPortfolio II = 40% S&P 500, 40% Lehman Brothers Gov./Corp. Bond and 20% EACM 100Portfolio III = 50% MSCI and 50% Lehman Brothers Global BondPortfolio IV = 40% MSCI, 40% Lehman Brothers Global Bond and 20% EACM 100EACM 100 = Index of Hedge Fund Strategies

Hedge Funds: Return/Risk Performance


Return and Risk Tradeoff: 1990-2002

EACM Sytematic (CTA)

Lehman U.S. Aggregate Bond

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%

Annualized Standard Deviation

Annu

aliz

ed R

etur

n EACM 100

EACM Event Driven

EACM Equity Hedge

S&P 500EACM Relative Value

Hedge Funds Provide Higher Return Compared to Traditional Assets


Risk and Return of Stock, Bond and Hedge Funds: January 1990-December 2002

100% EACM 100

100% S&P 500

100% Lehman Bond

50% S&P 500 and 50% Lehman Bond

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Portfolio Annualized Standard Deviation

Portf

olio

Ann

ualiz

ed R

etur

nHedge Funds Provide Enhanced Return/Risk Performance


Performance: EACM Hedge Fund Strategies and Traditional Assets (January 1990-December 2002)

Return Standard Sharpe Minimum Correlation with Correlation withDeviation Ratio Monthly Return S&P 500 Lehman Bond

Relative ValueMarket Neutral 8.50% 3.21% 1.16 -2.62% -0.17 0.18Convertible Hedge 9.76% 5.27% 0.95 -6.90% 0.17 0.04Bond Hedge 6.30% 4.78% 0.32 -7.09% 0.18 -0.10Rotational 14.23% 6.35% 1.49 -13.98% 0.07 -0.14

Event DrivenArbitrage 8.56% 6.06% 0.63 -11.10% 0.49 0.11Bankruptcy 13.48% 6.43% 1.35 -8.17% 0.34 0.02Multi-Strategy 13.94% 5.26% 1.75 -8.29% 0.46 0.03

Equity HedgeDomestic Long 12.53% 15.41% 0.50 -15.11% 0.69 0.07Long/Short 16.11% 10.03% 1.13 -5.15% 0.24 -0.01Global/International 15.63% 10.94% 0.99 -9.17% 0.60 0.11

Global Asset AllocatorsDiscretionary 14.07% 9.19% 1.01 -15.87% 0.33 0.08Systematic 17.21% 16.20% 0.77 -9.85% -0.10 0.26

Short Selling 1.75% 22.11% -0.14 -12.99% -0.78 -0.06

S&P 500 9.68% 15.28% 0.32 -14.46% 1.00 0.16Lehman Bond Index 8.30% 4.25% 0.83 -2.45% 0.16 1.00

Hedge Fund Performance


Factor Correlations (January 1996-December 2002)

S&P 500 Lehman Bond Lehman Volatility ProxyIndex High Yield Equity

EACM 100 0.49 0.01 0.47 -0.34Relative Value 0.16 -0.22 0.40 -0.10

Market Neutral -0.16 0.18 -0.03 0.30Convertible Hedge 0.23 -0.09 0.46 -0.13Bond Hedge 0.18 -0.23 0.38 -0.14Rotational 0.09 -0.28 0.21 -0.13

Event Driven 0.53 -0.15 0.63 -0.50Arbitrage 0.53 -0.14 0.61 -0.54Bankruptcy 0.44 -0.15 0.56 -0.40Multi-Strategy 0.50 -0.13 0.59 -0.47

Equity Hedge 0.61 -0.10 0.43 -0.42Domestic Long 0.67 -0.07 0.47 -0.49Long/Short 0.32 -0.10 0.22 -0.23Global/International 0.58 -0.10 0.42 -0.35

Global Asset Allocators 0.23 0.39 0.18 -0.14Discretionary 0.53 0.05 0.49 -0.49Systematic -0.09 0.47 -0.13 0.18

Basis for Hedge Fund Performance


Tracking Factor Based Determinants of Hedge Fund Returns– US Case

EACM 100 Factor Replicating PortfolioTwenty-Four Montsh Rolling Regression

-6%

-4%

-2%

0%

2%

4%

6%

EACM 100 Replicating Portfolio

In Sample Regression results

Average Value of Estimated Coefficient

RSQ 0.444Intercept 0.004S&P 500 Total Return Index 0.09Lehman U.S. Government/Credit -0.107Lehman U.S. Corporate High Yield 0.342Straddle S&P100 0.000

Out of Sample Statistics (1/96-3/03) Mean StdevEACM 100 8.23% 4.89%Replicating Portfolio 4.05% 4.29%Error Term 4.18% 4.46%Correlation 53%


European Hedge Fund: Factor Analysis – Tracking Europe: Hennesee Europe Index Factor Replication

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Hennessee Europe Index Replicating Portfolio



RSQ 0.599Intercept 0.010DJ EURO STOXX 50 0.43FTSE 100 Future -0.151Merrill Lynch EMU Corporates, BBB Rated 0.617Merrill Lynch EMU Direct Governments, 10+ Yrs -0.252Straddle Return FTSE 100 (UKX) 0.002Straddle Return DJ EURO STOXX 50 (SX5E) 0.019

Out of Sample Statistics Mean StdevHennessee Europe Index -2.96% 3.35%Replicating Portfolio -7.05% 7.61%Error Term 4.09% 6.96%Correlation 40%


Long/Short: Factor Analysis – Tracking



RSQ 0.652Intercept 0.013DJ EURO STOXX 50 0.43FTSE 100 Future -0.194Merrill Lynch EMU Corporates, BBB Rated 0.391Merrill Lynch EMU Direct Governments, 10+ Yrs -0.166Straddle Return FTSE 100 (UKX) 0.009Straddle Return DJ EURO STOXX 50 (SX5E) 0.014

Out of Sample Statistics Mean StdevLong/Short Portfolio (Euro) -0.61% 3.47%Replicating Portfolio -8.02% 7.56%Error Term 7.41% 6.85%Correlation 43%

Europe: Long/Short Factor Replication

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Long/Short Portfolio (Euro) Replicating Portfolio


Tracking Style Based Determinants of Hedge Fund Returns US Case

EACM Hedge Equity Style Replicating PortfolioTwenty-Four Montsh Rolling Regression

-10%

-5%

0%

5%

10%

15%

20%

Jan-9

7

Apr-97

Jul-9

7

Oct-97

Jan-9

8

Apr-98

Jul-9

8

Oct-98

Jan-9

9

Apr-99

Jul-9

9

Oct-99

Jan-0

0

Apr-00

Jul-0

0

Oct-00

Jan-0

1

Apr-01

Jul-0

1

Oct-01

Jan-0

2

Apr-02

Jul-0

2

Oct-02

Jan-0

3

EACM Equity Hedge Domestic Opportunistic Replicating Portfolio



RSQ 0.533Intercept 0.008S&P 500 Total Return Index -0.20Russell 2000 0.487

Out of Sample Statistics (1/96-3/03) Mean StdevEACM Equity Hedge Domestic Opportunistic12.40% 11.97%Replicating Portfolio 4.52% 9.63%Error Term 7.88% 9.67%Correlation 62%


Hedge Funds: Style Based Long Short Equity Tracking

Tracking: Dow Jones Euro Stoxx 50, FTSE 100

Europe: Long-Short Style Replication

-6%

-4%

-2%

0%

2%

4%

6%

Long/Short Portfolio (Euro) Replicating Portfolio



RSQ 0.509Intercept 0.006DJ EURO STOXX 50 Future 0.32FTSE 100 Future -0.117

Out of Sample Statistics Mean StdevLong/Short Portfolio (Euro) -0.61% 3.47%Replicating Portfolio -5.66% 7.11%Error Term 5.05% 6.22%Correlation 48%


Asset Allocation: Active Asset Management

•Strategic Asset Replacement

•Tactical Asset Management


Hedge Funds in Active Asset Allocation

Portfolio Risk and Return Contribution

Stock Portfolio High Grade Bond Portfolio High YIeld Bond Portfolio

Hedge Fund Strategy

Market Neutral Equity Risk Diversifier Return Enhancer Risk Diversifier

Fixed Income Arbitrage Risk Diversifier Risk Diversifier Return Enhancer

Convertible Arbitrage Mixed Risk Diversifier Return Enhancer

Event Return Enhancer Risk Diversifier Return Enhancer

Merger Arbitrage Return Enhancer Risk Diversifier Return Enhancer

Distressed Return Enhancer Risk Diversifier Return Enhancer

Hedge Equity Return Enhancer Risk Diversifier Return Enhancer

CTA High Risk-Return/ Risk Diversifier High Risk-Return/ Risk Diversifier High Risk-Return/ Risk Diversifier


Traditional Mean Variance Optimization with Hedge Funds

Traditional Asset Classes Weights Sub TotalU.S. 30 Day TBill TR 5.0%

SB 1 Yr On-The-Run Treasury TR 5.0% 10%SB 3-7 Yr Treasury TR 5.0%SB 10+ Yr Treasury TR 10.0%

SB Hi-Yld TR 5.0%SB AAA/AA Corp TR 10.0% 30%

Russell 1000 TR 40.0%Russell 2000 TR 10.0% 50%MSCI EAFE TR 5.0%

MSCI Emerging Market Free USD5.0% 10%


Hedge Funds Replace Traditional Assets Change in Allocation

U.S. 30 Day Tbill TR (Total Return) -3.7% -3.5% -3.7% -4.5% -4.1%SB 3-7 YR Treasury TR (Total Return) 0.0% 0.0% 0.0% 0.0% -0.5%SB 10+ Tr Treasury TR (Total Return) 0.0% 0.0% -0.6% 0.0% -0.1%SB Hi-Yld TR (Total Return) -1.0% -1.3% -0.1% -0.3% 0.0%Russell 1000 TR (Total Return) 0.0% 0.0% -0.5% 0.0% 0.0%Russell 2000 TR (Total Return) -0.3% -0.1% 0.0% 0.0% -0.2%MSCI EAFE TR (Total Return) 0.0% 0.0% 0.0% 0.0% 0.0%MSCI Emerging Markets Free USD -0.1% -0.1% 0.0% -0.2% 0.0%

HFRI Relative Value Arbitrage Index 5.0%HFRI Convertible Arbitrage Index 5.0%HFRI Statistical Arbitrage Index 5.0%HFRI Fixed Income: Arbitrage Index 5.0%HFRI Equity Market Neutral Index 5.0%

Annualized Mean of Port With Hedge Fund 11.23% 11.13% 11.09% 11.05% 11.14%Annualized Std of Port With Hedge Fund 9.43% 9.43% 9.43% 9.39% 9.43%Annualized Mean of Trad Asset Class 10.88% 10.88% 10.88% 10.88% 10.88%Annualized Std of Trad Asset Class 9.43% 9.43% 9.43% 9.43% 9.43%


Hedge Funds Replace Traditional Assets Change in Allocation

U.S. 30 Day Tbill TR (Total Return) -1.1% -3.6% -2.0% -2.7%SB 3-7 YR Treasury TR (Total Return) 0.0% 0.0% 0.0% 0.0%SB 10+ Tr Treasury TR (Total Return) -1.9% 0.0% 0.0% 0.0%SB Hi-Yld TR (Total Return) -0.7% -0.9% -2.4% 0.0%Russell 1000 TR (Total Return) 0.0% -0.1% 0.0% -0.1%Russell 2000 TR (Total Return) -0.5% -0.4% -0.4% -1.9%MSCI EAFE TR (Total Return) -0.1% 0.0% 0.0% -0.2%MSCI Emerging Markets Free USD -0.6% 0.0% -0.3% -0.1%

HFRI Macro Index 5.0%HFRI Merger Arbitrage Index 5.0%HFRI Distressed Securities Index 5.0%HFRI Equity Hedge Index 5.0%

Annualized Mean of Port With Hedge Fund 11.32% 11.17% 11.21% 11.49%Annualized Std of Port With Hedge Fund 9.43% 9.43% 9.41% 9.44%Annualized Mean of Trad Asset Class 10.88% 10.88% 10.88% 10.88%Annualized Std of Trad Asset Class 9.43% 9.43% 9.43% 9.43%


Ranked by S&P 500 Returns (1990-2002)

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

1 2 3 4

Aver

age

Mon

thy

Ret

urn

for R

anke

d Po

rtfo

lios

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

S&P

500

HFR Convertible Arbitrage Index HFR Equity Hedge Index HFR Event Driven Index

HFR Distressed Securities Index HFR Merger Arbitrage Index HFR Equity Market Neutral Index

HFR Fixed Income Arbitrage Index HFR Relative Value Arbitrage Index HFR Statistical Arbitrage Index

S&P 500 Total Return Index

Hedge Fund Selection Determined By Economic Forecast


Ranked by Lehman US Aggregate Returns (1990-2002)

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1 2 3 4

Aver

age

Mon

thly

Ret

urn

for R

anke

d Po

rtfo

lio

HFR Convertible Arbitrage Index HFR Equity Hedge Index HFR Event Driven IndexHFR Distressed Securities Index HFR Merger Arbitrage Index HFR Equity Market Neutral Index

HFR Fixed Income Arbitrage Index HFR Relative Value Arbitrage Index HFR Statistical Arbitrage IndexLehman U.S. Aggregate

Tactical Asset Allocation: Hedge Fund Selection by Economic Forecast


Conclusions

Risk and Return Analysis That Works for Traditional Assets Works for Hedge Fund Analysis.

Hedge Funds and CTAs Provide Risk And Return Opportunities Consistent With Their Exposure To Various Market Opportunities as well as Trader Skill.

Modern Methods Of Asset Allocation That are Used To Determine Source of Return To Stocks and Bonds Can Be Used To Determine Source of Returns to Hedge Funds.

1 the benefits of hedge funds the first seoul international derivatives securities conference thomas...

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