democratization of hedge funds redefining alpha and beta in hedge fund returns

Democratization of Hedge FundsRedefining Alpha and Beta in Hedge Fund Returns

Yazann Romahi, PhD, Managing DirectorGlobal Head of Research & Quantitative Strategies

Asset Management Solutions, JPMorgan Asset Management

2013

What is today’s talk about?

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3

Overview

What is Alternative Beta

Equity Based Hedge Funds– HFRI Merger Arbitrage– HFRI Equity Hedge (Long/Short)– HFRI Equity Market Neutral Index– HFRI Short Bias Index– HFRI Emerging Markets Index

Fixed Income Hedge Funds– HFRI Convertible Bond Arbitrage– HFRI RV Fixed Income Corporate Index

Alternative Beta – NOT hedge fund replication

An aside: Reverse Engineering Your Competitors

To Index or not to Index

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Understanding alpha and beta

Risk premium:– Beta is the return that can be explained by any systematic exposure to an economic risk premium

Stock selection Key to Equity Return

Equity Beta as a GrowthRisk Premium Investable

Pre-1975

αβ

α

Size & Value identifiedas separate risk premia

ββValue

βSmall Cap

α

Momentum describedas a persistent risk premium

ββValue

βSmall Cap

βMomentum

α

Bogle launches first index fund

Fama-French 3 factor model

Carhart 4 factor model

1975 1993 1997

Source: J.P. Morgan Asset Management. For illustrative purposes only.

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Alternative Beta: Definition

Alternative beta is defined as the returns to factor risks uncorrelated to market risk that can be captured through a systematic exposure to an alternative risk premium (often long/short) that forms a component of traditional hedge fund returns

Traditional Investments Alternative Investments

Traditional beta captured throughsystematic risk exposures

Alpha

Alpha(inclusive of the illiquidity premium)

For illustrative purposes only.

Alternative beta captured throughsystematic risk exposures

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What Alternative Beta is NOT!

Just because hedge fund indices can be replicated does not mean that they should be replicated

Alternative Beta is NOT Hedge Fund Replication

We will show in this presentation how a large portion of hedge fund returns can be captured through traditional beta exposures

The aim of Alternative Beta is to capture the component of hedge fund returns that is a beta uncorrelated to traditional beta

7

Overview







Merger Arbitrage

What is it?– Merger arbitrage involves the hedge fund manager buying into the stock of a company subject

to a takeover bid while shorting the stock of the acquirer company

Source of “Alpha”?– Ability of manager to limit exposure to “failed” deals through research

– Effectiveness of “alpha” overlay limited due to necessity of portfolio concentration (there are typically 80-100 investable deals globally at any one time)

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What is Merger Arb?

3G Capital looked to acquire Burger King and made an offer on 2/9/2010

Given that this was a friendly deal with a high likelihood of success, the premium available was limited. We bought the stock at USD 23.59, selling it to 3G Capital for USD 24

The deal completed on October 20th and thus earned 1.7%

While this may initially sound low, this was over a 2 month period roughly equating to an annualised figure of over 10%

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Source: Bloomberg October 2010For illustrative purposes only. The inclusion of the securities mentioned above is not to be interpreted as recommendations to buy or sell.

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25Burger King

Pric

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24Burger King

bought

sold

Example of failed bid: MacArthur Coal

Peabody Energy make an unsolicited offer for MacArthur Coal on March 30, 2010 at $13 per share

New Hope Corp counter on April 9, 2010 and 4 days later increase their bid by 7.44% to $14.50 per share

Peabody Energy counter on May 10 with an offer of $16

After Australia introduces a 40% tax on mining profits, Peabody reduces its bid to $15 per share

The board rejects the offer and MacArthur Coal drops to $10.10

As the market had been expecting counterbids, our entry price was at $14.80

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Source: Bloomberg

Pric

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bought

For illustrative purposes only. The inclusion of the securities mentioned above is not to be interpreted as recommendations to buy or sell. Past performance is not indicative for future performance. The Fund is an actively managed portfolio subject to change.

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Return per merger deal

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lsWhy is there a risk premium?

Diversification is central to merger arbitrage – more names reduces idiosyncratic risk

High levels of merger activity are positive for the strategy

Average return to a merger arbitrage deal

Source: MergerStat, Bloomberg, JPMAM. Jan 1999 to Jul 2011. For illustrative purposes only. Opinions and analysis are JPMAM’s judgment and can be subject to change without notice.

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Types of merger activity

Deals completed with acquirer stock signals strong valuations

When cash is cheap companies will prefer cash funded acquisitions over stock funded acquisitions

Source: Bloomberg, JPMAM as at 31st March 2012. For illustrative purposes only. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice..

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Dot com bubble – more stock deals

Credit bubble – more cash deals

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A diversified portfolio limits downside risk

The evidence supporting the hypothesis that the merger arbitrage strategy is akin to a short put is weak.

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Cash Mergers - Monthly Return of the strategy

S&P Monthly Return

Stock for Stock Manager - Monthly Return of the strategy

Source: MergerStat, Bloomberg, JPMAM. Jan 1999 to Jul 2011. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

Return to merger arbitrage

S&P Monthly Return

Return to merger arbitrage

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While North American deals are most active in mergers and acquisitions, European and to a lesser extent Asia Pacific deals do provide a significant amount of diversification

In the current environment, North American deals dominate the portfolio

Source: Bloomberg. As at 31st March 2012.

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Diversification is key

No. of deals

The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

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Active Merger Arbitrage vs “Passive” Merger Arbitrage

We create a portfolio of the merger arbitrage “risk premium” – an equally weighted portfolio of stocks subject to takeover (with the corresponding short)

Return is leveraged by approximately 20%

Portfolio performance is calculated using a static weight of the asset illustrated above, monthly rebalancing gross of fees. Sources: J.P. Morgan Asset Management, Bloomberg. Analysis period January 1991 to December 2011.Past performance is not a guide to the future.

HFRI Merger

ArbitrageSystematic merger arbitrage

Return 7.77% 7.97%

Risk 3.62% 5.30%

IR 1.16 0.83

Drawdown 8.27% 12.57%

Longest underperformance

21 21 Jan-94 Jul-96 Jan-99 Jul-01 Jan-04 Jul-06 Jan-09 Jul-110%

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Systematic Merger Arbitrage HFRI Merger Arb

16

Overview







17

Understanding alpha and beta

Risk premium:– Beta is the return that can be explained by any systematic exposure to an economic risk premium

Stock selection Key to Equity Return

Equity Beta as a GrowthRisk Premium Investable

Pre-1975

αβ

α

Size & Value identifiedas separate risk premia

ββValue

βSmall Cap

α

Momentum describedas a persistent risk premium

ββValue

βSmall Cap

βMomentum

α

Bogle launches first index fund

Fama-French 3 factor model

Carhart 4 factor model

1975 1993 1997

Source: J.P. Morgan Asset Management. For illustrative purposes only.

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Portfolio performance is calculated using a static weight of the asset illustrated above, monthly rebalancing gross of fees. Past performance is not a guide to the future.Sources: JP Morgan Asset Management, Bloomberg. Analysis period January 1995 to December 2012.

Equity Long Short Index is a combination of risk premia

Equity Long/Short index is essentially a combination of a number of factor risks:– Static 75% weight to MSCI World– Equal allocations to a number of risk premia including

the value premium, size premium, momentum and minimum volatility

The importance of understanding the nature of alternative beta allows the investor to distil the truly uncorrelated factor exposures from those that may be doubling up exposure elsewhere in the portfolio

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75% MSCI World + 60% Alt Beta HFRI Equity Hedge Index

MSCI World

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Overview







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HFRI Equity Market Neutral

Equity Market Neutral can be captured with an equal risk exposure to Market Neutral Value and Market Neutral Momentum. Coupled with a MSCI World Beta of 0.1, this gives us an R2 of 45%

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Portfolio Factor Model

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Overview







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HFRI Short Bias

HFRI Short Bias can be captured with a full risk exposure to Market Neutral Value (100% gross leverage). In addition is an equity beta of -0.75. Together, this gives us an R2 of 85%

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Overview







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HFRI Emerging Markets

HFRI Emerging Markets can be captured with a full risk exposure to MSCI EM with a small bias to Momentum (market neutral) and Minimum Volatility (market neutral). R2 = 85.7%

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Overview







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HFRI Convertible Arbitrage

R2 = 67%. Long CB, Long HY and long Investment Grade Credit; Short Duration; Short Equity

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Overview







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HFRI RV Fixed Income Corporate Index

R2 = 68%. Long HY (mainly) with some Investment Grade Credit and Short Duration

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Overview







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Seeing through the alpha smokescreen . . .

A significant amount of “alpha” from hedge funds can be attributed to systematic factors One of the advantages of investing in hedge funds is accessing these uncorrelated sources of risk premia We seek to provide a liquid, transparent alternative to access these uncorrelated sources of return

Increasing order of complexity

For illustrative purposes only. The targets and aims provided above are the Investment Manager’s targets and aims only and are not part of the Funds investment objective and policy as stated in the Fund’s prospectus. There is no guarantee that these targets and aims will be achieved. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

Traditional Beta AlphaAlternative Beta

Equity PremiumCredit Premium

Commodity (GSCI)Emerging Debt

Small Cap PremiumValue Premium

Emerging EquityCommodities Roll Yield

Relative Bond Yield CurveConvertible ArbitrageEquity Momentum

Commodities Momentum

Term Premium

Forward Rate Bias

Relative Bond Carry

FX Momentum

Manager DrivenNon-systematic

Idiosyncratic

High Frequency

REIT Merger Arbitrage

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Alternative beta have had low correlations to traditional beta

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Sources: J.P. Morgan Asset Management, Bloomberg, UBS Global Focus Convertible Bond index, Merger Stat, Citigroup WGBI Index. Analysis period January 1998 to December 2012.

MSCI World MSCI EM WGBI High Yield EMBI GSCI

Value -0.14 -0.13 -0.05 -0.09 -0.16 0.06

Momentum 0.30 0.22 0.04 0.12 0.14 0.01

Size 0.19 0.32 -0.07 0.31 0.22 0.12

Low beta / minimum volatility -0.51 -0.46 0.05 -0.36 -0.25 -0.06

Convertible bond arbitrage 0.13 0.30 0.02 -0.01 0.36 0.08

Systematic merger arbitrage 0.47 0.52 0.00 0.41 0.45 0.25

Long/Short G7 Term Premium -0.13 -0.05 0.02 0.01 0.01 -0.10

Long/Short G7 Carry 0.11 0.07 0.10 0.03 0.22 0.08

FX Carry 0.40 0.48 -0.03 0.39 0.26 0.30

FX Momentum 0.02 0.08 -0.05 -0.06 -0.14 0.08

Commodities Roll Yield 0.10 0.12 0.21 0.21 0.12 0.20

Commodities Momentum 0.01 -0.02 0.16 0.04 0.05 0.22

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Question How can we help?

Institutional client unable to access traditional alternatives due to high costs, illiquidity and/or a lack of transparency (manager risk)

Ability to provide alternative solutions in a low cost, liquid, and transparent fashion

Hedge Fund investor looking to increase the liquidity profile of their hedge fund investments

Analyse current exposures in their portfolio. Help them understand what alternative factors they may already have and where additional exposure may be beneficial. When requiring liquidity, a core/ satellite approach to alternative beta / high conviction alpha may be appropriate, thus allowing the client to increase exposure to alternatives while maintaining liquidity.

Hedge Fund investor in the process of searching for a high conviction manager and would like to hold the alternative beta exposure in the interim

Liquidity allows users to access the hedge fund style while they search for a high conviction manager. Similarly, daily liquid vehicles can be used for factor timing.

Possible uses of alternative beta solutions

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Source: J.P. Morgan Asset Management. For illustrative and discussion purposes only

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Reinsurance; 15%

Quantitative; 12%

Commodities; 10%

Traditional Macro; 26%

Emerging Markets; 22%

Non-Spread Credit; 15%

Alternative Beta as a component of a hedge fund allocation

As of December 31, 2012. Allocations are made at the manager's discretion and can be changed without notice. Manager count does not include investments in internal programs and managed co-investments. Strategy allocation information is estimated through December 31, 2012 and has been rounded.

1-3 managersDiversified by

style and instrument

1-2 managersDiversified by

attachment point and peril

1-3 managersDiversified by style

and market

1-3 managersDiversified across

markets

1-4 managersDiversified by style

and instrument

Alternative Beta

Alternative Beta can be used in a core/satellite approach to reduce the overall fee structure of the solution while improving its liquidity profile

A number of liquid hedge fund styles can be replaced by a lower cost, highly liquid component

Core Component in Alternative Beta

Satellite exposures to managers that deliver true idiosyncratic risk or exposure to illiquidity premia

Satellite exposures to idiosyncratic alpha

Alternative Alpha

Alternative Beta

1-2 managersDiversified by strategy

and instrument

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Overview







3535

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A large competitor

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Portfolio Excess Return Model Excess Return


Return 13.7% 13.7%Risk 7.2% 8.1%Sharp Ratio 1.9 1.3Max Drawdown 5.1% 7.1%

Competitor’s excellent performance over the past 4 years can be entirely explained by a fairly simple bet as highlighted by the replication above

The “Factor Model Portfolio” is a portfolio that is 2/3rds Investment Grade Credit (with the duration hedged out) plus 1/3 rd High Yield (R2=76%). There does also appear to be some currency momentum trading in there as well and a small amount of infrastructure equity

While we are not trying to detract from the fact that they successfully made that bet, the point is that it looks like they’ve had essentially one bet on for 4 years with a little bit of noise around it

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Overview







What Makes a Good Benchmark?

Investable

Appropriate

Informed Opinion

Unambiguous

Specified in advance

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Have we captured the merger arbitrage hedge fund style?

Merger arbitrage strategy since inception (*):HFRI ED: Merger arb index

Beta to MSCI World is 0.09

Volatility is 2.95% compared to 15.80% for the MSCI World index

Source: HFR, JPMAM, Bloomberg. As at 30th April 2013. * Inception Date – July 2009, performance is cumulative. Fees and charges for the C share class as follows: No initial charge, 0.75% annual management and advisory fee, 0.20% operating and administrative expenses and no redemption charge. performance of the merger arbitrage strategy within the JPMorgan Funds - Systematic Alpha fund to 31/03/11 and actual performance of the JPMorgan Investment Funds – Global Merger Arbitrage Fund thereafter.The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus.

+15.83% (net of C share class fees)+15.26% (net of fees of typically 2/20)

Appendix

39

Long/short equity: back-tested performance

In line with the hedge fund style, 2009 was poor

However 2010 was positive and subsequent gains have taken the fund above its previous peak

Source: Factset, Bloomberg, J.P. Morgan Asset Management, 30th April 2013.For illustrative purposes only. Fund inception 1 July 2009.

Historical performance analysis

Periods to 30th April 2013Equity

Long/ShortMSCI World

Excess return (annualised) 6.0% 4.1%

Risk 5.9% 16.0%

IR 1.01 0.05

Maximum drawdown 10.9% 55.4%

Beta -0.11

The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The back-tested period consists of the performance of the Equity Long/Short (beta neutral) strategy. The model captures the alternative risk premia embedded in the style by going long value stock with positive momentum subject to quality constraints. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Past performance is not indicative of future results. MSCI: Morgan Stanley Capital International. *Performance includes backtested data from 31/01/96 to 30/06/09 and performance of the equity long/short strategy within the JPMorgan Funds - Systematic Alpha fund thereafter.

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400% Equity long/shortMSCI World

Live performance*→→

Equity Long/Short - diversified, systematic capture of risk premia

Risk Premium

Strategy: – Long “cheap” stocks, Short “expensive” stocks (as measured by P/E,

Div Yld etc)

– These factors form the backbone of many quantitative & qualitative equity products and drive most equity investment philosophies.

Value premium

Risk Premium

Strategy: – Buy small cap stocks; short large cap stocks

Size premium

Return Chasing & Market Bias

Strategy: – Long positive earnings revision stocks, short negative revision stocks

– Buy stocks whose momentum is in the top decile while shorting those in the bottom decile

Momentum

Behavioural bias

Strategy: – Long positions with decreasing accruals, short stocks with growing

accruals; – Long positions with low beta, short stocks with high beta

Quality

For illustrative and discussion purposes only. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided above are the Investment Manager’s targets and aims only and are not part of the Funds investment objective and policy as stated in the Fund’s prospectus. There is no guarantee that these targets and aims will be achieved.

The Value Premium : 1927-present

Academic explanations remain incomplete at best– EMH: Fama-French describe it as a priced risk factor.

They argue that stocks with high book-market are more likely to be subject to financial distress and more correlated to the business cycle

– Behavioral finance: the literature here suggests that cognitive biases underlying investor behaviour are at the root of the premium. Specifically irrational investors tend to have exaggerated hopes for growth/glamour stocks and overly pessimistic outlook on value stocks

– Outlook: The increasing prevalence of ETFs and of passive market investments is exacerbating the premium

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Fama-French Value: 1927-present

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The Value Premium : 1927-present

One of the most interesting aspects of the value premium is the positive skew it brings in addition to its positive excess return over time

It should also be noted that as seen in the returns since 1927, the value premium has not diminished since Graham and Dodd’s 1934 treatise.

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Value Quintile Returns vs Universe

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Fama-French Size Premium

The size effect can go through long periods of underperforms

Outlook:– The growth of ETFs and the growing acceptance of beta is in

fact exacerbating both the value and size premia

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The Size Premium : 1927-present

Drawdowns are significant with long periods of underperformance

However, as seen with the value premium, the size premium is a positively skewed strategy which has significant benefit in a portfolio of exotic beta

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Momentum : 1927 - present

Momentum exists in all financial time series– The persistence of this anomaly is the biggest threat to EMH

– Behavioural finance advocates offer explanations based on non-rational behaviour generating abnormal inertia

Outlook:– Momentum generally performs poorly at market turning points

– The question going forward is whether we are entering into an environment with shorter economic cycles

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Fama-French Momentum: 1927-present

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Momentum Distribution and Skew : 1927-present

The momentum factor exhibits significant negative skew

Can it therefore be considered compensation for bearing negative skew?

47

Momentum Backtest : 1990 – present

From 1990, redefine it in sector neutral, country neutral momentum

The results are similar and the negative skew is still pronounced

0.00

0.50

1.00

1.50

2.00

2.50

Jan-

90

Jan-

92

Jan-

94

Jan-

96

Jan-

98

Jan-

00

Jan-

02

Jan-

04

Jan-

06

Jan-

08

Jan-

10

48

Momentum Quintile Returns vs Universe

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5

Low Risk Investing – Beta and Volatility

The outperformance of low beta/volatility stocks over high beta/volatility stocks is one of the biggest challenges to CAPM

Unsurprisingly, all explanations in the literature are behavioural based.

Most active money is delegated to managers whose performance is measured relative to a market index. As these managers are usually limited in any leverage they may use, low beta stocks will therefore look risky.

Investors tend to favour higher volatility stocks because they underestimate the risk of stocks that offer the allure of a really high payout – highly volatile stocks. An alternative but related explanation is that they favour stocks that consistently are in the news (typically high volatility stocks)

49

Low Beta as an Investment Signal

Creating a portfolio based on low beta stocks while hedging with high beta stocks add value though the turnover is relatively high

The strategy experiences significant underperformance during “dash to trash” rallies

Surprisingly, the strategy is also negatively skewed and the quintile dispersion is not monotonic as only the extremes appear to add value

50

Macro Based Risk Premia

Global Macro has Significant Dispersion Amongst Underlying Managers

In the macro space, there isn’t a single premium that can explain the style so we focus instead on understanding the different risk premia that exist

Here we list a number of risk premia common in the macro space– Bond Futures: Although the term premium is considered a traditional beta, converting this into a long/short duration neutral

relative term premium transforms this into an exotic beta

– FX: One of the most commonly known behavioural biases in FX is the Forward Rate Bias. We implement this amongst both G10 & EM countries and build a relative momentum model to augment this

– Commodities: The term structure in commodities generally reflects both expected changes in spot prices as well as an insurance premium If hedgers are net short, the term structure is likely to be backwardated* and thus a long position will earn a risk premium Likewise, if hedgers are net long, then contango* is likely and thus short positions earn a risk premium

*Please see the Glossary of Terms in Appendix. The aims and objectives provided above are the investments manager’s aims and objectives and do not necessarily reflect the investment objective and policy of the Fund as stated in the Prospectus. There is no guarantee that these aims and objectives will be achieved. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

The Macro risk premium in our strategy

Fixed income– Long the long end of steepest curves and short the long end of the flattest curves

– Long the highest carry bond markets and short the lowest carry bond markets

– 7 developed bond markets

Currency – 10 developed market currencies – momentum and carry negatively correlated

Momentum – Price Momentum to capture autocorrelation in price series and equity momentum to capture a flow proxy Carry – Forward rate bias: Long the highest yielding currencies with rising rates and short the lowest yielding currencies with

decreasing rates

– 20 Emerging Market Currencies: Forward Rate Bias Strategy though no positions taken in currencies of countries where the CDS prices are implying an implied probability of default greater than 15%

Commodities– 20 commodities - constituents of GSCI and DJUBS indices

Roll Yield – long backwardated commodities and short those in contango Momentum – Commodities exhibit the highest autocorrelation of all financial timeseries

The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus.

Jan-9

5

Feb-96

Mar-97

Apr-98

May-99

Jun-0

0Ju

l-01

Aug-02

Sep-03

Oct-04

Nov-05

Dec-06

Jan-0

8

Feb-09

Mar-10

Apr-11

May-12

-3%

2%

8%

13%

18%

22%

28% Bond Bond Live performance*→→

Fixed Income Macro PremiaFixed Income Backtest Performance Fixed Income live track record

The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Performance includes backtested data from 31/12/94 to 30/06/09 and performance of the Fixed income strategies within the JPMorgan Funds - Systematic Alpha fund thereafter.

Source: Bloomberg, J.P. Morgan Asset Management, as at 30 th April 2013. Fund inception 1 July 2009. For illustrative purposes only. Past performance is not indicative of future results. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time.

Annualised return 1.08%

Volatility 1.49%

Sharpe Ratio 0.73

Jul-0

9

Oct-09

Jan-1

0

Apr-10

Jul-1

0

Oct-10

Jan-1

1

Apr-11

Jul-1

1

Oct-11

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2

Apr-12

Jul-1

2

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3

Apr-13

-1.0%

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3.0%

4.0%

5.0%

6.0%

7.0%Bond Bond

Since inception, the factors within the fixed income strategy have been giving offsetting signals.

For this reason, risk taken within the strategy has been low, leading to performance that has been broadly flat.

May-91

Aug-92

Nov-93

Feb-95

May-96

Aug-97

Nov-98

Feb-00

May-01

Aug-02

Nov-03

Feb-05

May-06

Aug-07

Nov-08

Feb-10

May-11

Aug-12

-10%

40%

90%

140%

190%

240%FX G10

Live performance*→→

FX Macro Premia

FX G10 backtest & live performance

Source: Bloomberg, J.P. Morgan Asset Management, as at 30th April 2013. Fund inception 1 July 2009For illustrative purposes only. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Past performance is not indicative of future results. *Performance includes backtested data from 31/04/91 to 30/06/09 and performance within the Systematic Alpha Fund thereafter.


Volatility 5.00%

Sharpe Ratio 1.08

FX EM backtest & live performance

Apr-97

Mar-98

Feb-99

Jan-0

0

Dec-00

Nov-01

Oct-02

Sep-03

Aug-04

Jul-0

5

Jun-0

6

May-07

Apr-08

Mar-09

Feb-10

Jan-1

1

Dec-11

Nov-12

-10%

10%

30%

50%

70%

90%

110%

130%FX EM Live performance*→→


Volatility 5.03%

Sharpe Ratio 0.89

Commodity Macro Premia

Commodity Backtest performance

Source: Bloomberg, J.P. Morgan Asset Management, 28th February 2013.For illustrative purposes only. Past performance is not indicative of future results. Fund inception 1 July 2009. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward.

Aug-97

Jul-9

8

Jun-9

9

May-00

Apr-01

Mar-02

Feb-03

Jan-0

4

Dec-04

Nov-05

Oct-06

Sep-07

Aug-08

Jul-0

9

Jun-1

0

May-11

Apr-12

-10%

10%

30%

50%

70%

90%

110%Commodities


Volatility 5.00%

IR 0.88

In the past, a significant proportion of the roll yield could be captured by being long the commodity due to most commodities being in backwardation.

This is no longer true, with most commodities today being in contango. Indeed the most backwardated commodity is soybeans, with an annualised yield of 14.8%. In comparison, the commodity in greatest contango, lean hogs, has a negative yield of 33.9%.

More on CBs

58

What is a convertible bond?

Debt Characteristics: Principle repayment at a future date

Periodic coupon payments

Priced as a percentage of par

Often “puttable” at investor’s option

Often callable at issuer’s option

Debt EquityOption

Source: KBC Financial Products

Equity Option Characteristics: Conversion into shares during

the life of the bond Fixed conversion price, at a

premium to the current share price

Fixed number of shares per bond

59

Spectrum of convertible profiles

Definitions: Equity-like = vanilla convertibles with premium < 15%; Balanced = convertibles with a premium < 100% and an annualised premium < 20%; Bond-Like = convertibles with a premium > 100% or annualised premium > 20%

Convertibles can exhibit a number of different profiles, depending upon the value of the embedded optionality

Equity-like

Option is in-the-money, and these securities exhibit a high degree of equity sensitivity. Equity-like convertibles are most exposed to changes in the underlying share price

BalancedProvide a mixture of equity and credit exposure. The convertible will be trading slightly above the bond floor, which will provide some protection on the downside if equity prices decline; in a positive scenario, delta will increase quickly and the optionality will increase in value, providing significant upside participation

Bond-likeOption is significantly out-of-the money and the probability of conversion is low. These securities have little equity sensitivity, and the primary driver of returns is the coupon and yield to maturity, as well as any changes in credit conditions

Bond Floor

Conversion Premium

Convertible Price

Parity

Bond-like convertible

Balanced convertible

Equity-like convertible

Equity price

Con

vert

ible

pric

e

Theoretical convertible payoff curve

60

Convertible Bonds : A Hybrid Asset Class

Convertible Bonds are a hybrid asset class made up of several risk premia:

High Yield

Small Cap Premium

Equity Risk Premium

Embedded Optionality (can be considered a liquidty risk premium)

Portfolio performance is calculated using a static allocation based on the weights illustrated above with monthly rebalancing and gross of fees. Sources: Please see disclosure slide for data sources: Analysis period January 1994 to December 2011.Past performance is not a guide to the future.

61

Convertible Bond Arbitrage

Portfolio performance is calculated using a static allocation based on the weights illustrated above with monthly rebalancing and gross of fees. Sources: Please see disclosure slide for data sources: Analysis period January 1994 to December 2011.Past performance is not a guide to the future.

Jan-9

6

Oct-96

Jul-9

7

Apr-98

Jan-9

9

Oct-99

Jul-0

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Apr-01

Jan-0

2

Oct-02

Jul-0

3

Apr-04

Jan-0

5

Oct-05

Jul-0

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Apr-07

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8

Oct-08

Jul-0

9

Apr-10

Jan-1

10%

20%

40%

60%

80%

100%

120%

140%

HFRI CB Arb CB Arb Replicating Portfolio

Convertible bond arbitrage MSCI World

Return 6.1% 3.3%

Risk 7.8% 16.3%

IR 0.78 -0.01

Drawdown 19.7% 55.4%

Correlation matrix MSCI World MSCI EM WGBI High Yield EMBI GSCI

Convertible bond arbitrage

-0.02 0.05 0.16 0.28 0.24 0.04

Convertible Bond (CB) arbitrage is a hedge fund style where, like merger arbitrage, there exists a common risk factor amongst the participants.

CB’s trade at a discount to the sum of its parts – straight bond plus a call option on the underlying.

– The premium is essentially an illiquidity and small cap. premium.

– To eliminate this, the arbitrageur will typically look to hedge the equity and duration sensitivity.

Cross-Correlation between and within traditional and alternative beta

62

MSCI

World Value Mom. SizeMin.

VolatilityMerger

Arb. WGBI EMBI Term Prem.

Real Yield

High Yield

Convert. Arb. REITs GSCI

MSCI World 1.0

Value -0.2 1.0

Momentum -0.3 -0.1 1.0

Size 0.1 -0.4 0.1 1.0

Minimum volatility -0.2 0.1 0.1 0.0 1.0

Merger arb. 0.4 -0.2 0.0 0.3 0.0 1.0

WGBI -0.1 0.1 0.2 -0.2 0.0 -0.1 1.0

EMBI 0.5 -0.1 -0.1 0.1 -0.1 0.4 0.2 1.0

G7 Term Premium -0.2 -0.1 0.1 -0.1 0.2 0.0 -0.0 -0.1 1.0

G7 Real Yield 0.0 0.0 0.0 0.0 -0.1 0.0 -0.0 0.0 -0.3 1.0

High Yield (spread) 0.6 0.0 -0.4 0.3 -0.1 0.3 0.0 0.5 -0.2 0.0 1.0

Convertible bond arb. -0.2 -0.4 0.4 0.4 0.0 0.2 0.1 0.2 0.1 0.0 0.1 1.0

REITs (beta hedged) -0.3 0.5 -0.1 0.2 0.1 -0.1 0.1 0.0 -0.2 0.0 0.1 -0.1 1.0

GSCI 0.3 0.0 0.1 0.1 0.1 0.2 -0.1 0.2 -0.1 -0.1 0.2 -0.1 -0.1 1.0

Sources: Please see disclosure slide for data sources: Analysis period January 1991 to December 2011.

Bibliography

63

Bibliography

[1] Jegadeesh, Narasimham, and Titman, Sheridan, 1993. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance 48, 93-130.

[2] Fama E F and K R French, 1992, "The Cross-Section of Expected Stocks Returns", Journal of Finance 47, 427-465.

[3] Jaeger, Lars and Wagner, Christian, “Factor Modeling and Benchmarking of Hedge Funds: Can Passive Investments in Hedge Fund Strategies Deliver?”, Journal of Alternative Investments

[4] Ang, Andrew, Robert J. Hodrick, Yuhang Xing & Xiaoyan Zhang (2006), The cross-section of volatility and expected returns, Journal of Finance, Vol. LXI, No. 1, February 2006, pp. 259-299

[5] Black, Fischer, Michael C. Jensen, and Myron Scholes (1972), The capital asset pricing model: some empirical tests, Studies in the theory of capital markets (Praeger)

[6] Fama, Eugene F., and James D. MacBeth (1973), Risk, return and equilibrium: Empirical tests, Journal of Political Economy 71, pp. 43-66

[7] Blitz David C and van Vliet Pim (2007), The volatility effect: lower risk without lower return, Journal of Portfolio Management

[8] G Jensen and J Rotenberg, “Hedge Funds Selling Beta as Alpha” (2003)

64

Bibliography (cont)

[9] Agarwal V, Fung W, Loon Y C, Naik N, “Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market”, London Business School Working Paper, 2006

[10] Bohn, Henning & Tesar, Linda L, 1996. "U.S. Equity Investment in Foreign Markets: Portfolio Rebalancing or Return Chasing?," American Economic Review, American Economic Association, vol. 86(2), pages 77-81, May.

[11] Victor L. Bernard and Jacob K. Thomas , “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings”, The Journal of Accounting and Economics, Volume 13 (1990), 305-340

[12] Sloan. (1996). Do Stock Prices Fully Reflect Information in Cash Flows and Accruals About Future Earnings. The Accounting Review, Volume 71, Issue 3 (July, 1996), 289-315.

[13] Xie. (2001). The Mispricing of Abnormal Accruals. The Accounting Review, Volume 76, Issue 3 (July, 2001), 356-373.

[14] Vikas Agrawal, William H. Fung, Yee Cheng Loon, and Narayan Y. Naik, "Risks in Hedge Fund Strategies: Case of Convertible Arbitrage“, London Business School Working Paper, 2006

[15] Fan Yu, “How Profitable Is Capital Structure Arbitrage?”, Financial Analysts Journal, September 2006, Vol. 62, No. 5: 47-62

65

Bibliography (cont) [16] Gurdip Bakshi & Nikunj Kapadia, 2003."Delta-Hedged Gains and the Negative Market Volatility Risk Premium,“,

Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 16(2), pages 527-566.

[17] Ser-Huang Poon, Clive Granger, "Practical Issues in Forecasting Volatility", Financial Analysts Journal, Vol 61(1), 2005.

[18] Bollerslev T, Gibson M, Zhou H (2006), “Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option Implied and Realized Volatilities”, AFA Boston Meetings Paper 2006.

[19] Canina L. and S Figlewski, (1993), “The Informational Content of Implied Volatility”, Review of Financial Studies, Vol 6(3), pp 659-581

[20] Jorion P, (1995), “Predicting Volatility in the Foreign Exchange Market”, Journal of Finance, Vol 50(2), pp 507-528

[21] Galati, G and K Tsatsaronis, (1996), “The information content of implied Volatility from Currency Options”, Bank of International Settlements

[22] Amin K.I and V.K. Ng, (1997), “Inferring Future Volatility from the Information in Implied Volatility in Eurodollar Options: A New Approach”, Review of Financial Studies, Vol 10, No. 2, pp 333-367

[23] Christensen, B.J and N.R. Prabhala, (1998), “The Relation Between Implied and Realized Volatility”, Journal of Financial Economics, 50, pp 125-150

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66

Focusing on the creation of liquid vehicles to enable access to alternative beta

Creation of multistrategy diversified solutions for those wanting diversified liquid alternatives exposure

Recent media interest has resulted in more interest– Significant coverage in prominent media such as NRPN and FTfm, IPE

amongst others

What are we doing at JPMorgan?

67

democratization of hedge funds redefining alpha and beta in hedge fund returns

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