hedge fund strategy outlook summary - j.p. morgan · 23 relative value equity market neutral 24...

Hedge Fund Strategy Outlook SummaryOur views on which hedge fund strategies are poised to perform... and our tolerance for riskFebruary 2012 | H E D G E F U N D R E S E A R C H

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Investors in hedge funds need to balance their bottom-up manager selection with a well conceived strategy outlook and allocation framework.

We rebalance our portfolios monthly, and in doing so we attempt to maximize the allocations to sub-strategies that we think have the best near term prospects. To arrive at an overall outlook for each strategy, we consider the specific opportunities (or lack thereof) for each strategy, as well as the overall macro environment which guides the weights we place on each strategy factor.

Macro EnvironmentOur current return score is “3”, as we see the potential for attractive returns in a number of areas, but there are not widespread opportunities to invest at significantly attractive valuations. Opportunities in non directional strategies are slightly below average, although pockets of significantly stronger opportunities exist. Risk premi-ums in credit and equity are above average, even after factoring significant and pos-sibly growing economic head winds. The low interest rate environment is supportive for risk assets but there is a headwind for traditional arbitrage strategies.

Our current risk score is “3.5”, as we view the risk to hedge funds as elevated. The primary concern remains the European debt situation and its possible implications. Policy makers have shown improved ability to focus on resolving the issues instead of

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Calvin Ho, CFA(65) 68821085

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Pascal Bougiatiotis +44-207-742-2274

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Raphael Guiragossian, CAIA+41-22-744-1926

EXHIBIT 1: RISK/RETURN HEAT MAP KEY

Source: J.P. Morgan Alternative Asset Management.

5

Ret

urn

outl

ook

3

4

2

1

53 421Risk in the environment

January2012

Hedge Fund Strategy Outlook Summary

2 | Hedge Fund Strategy Outlook Summary: Our views on which hedge fund strategies are poised to perform... and our tolerance for risk

obfuscating them. Still, mismanagement of the situation could cause liquidity/banking crisis type situations. Monetary sup-port has grown more politicized, with uncertainties in timing, magnitude and the expected impact.

These scores mandate how we weight certain factors (see Exhibit 3 in the next section), which impacts the overall rank-ing for a strategy as well as the actions we take from a struc-tural/portfolio management perspective.

Exhibit 2 shows the historical ratings since the second quarter of 2008. As shown the return environment has improved recently, but the risk in the global economy and capital markets has remained elevated.

Given the macro environment, below are the actions and preferences we are employing in our manager selection and portfolio construction process:

• Emphasize uncorrelated strategies (uncorrelated to broader markets and ideally to other hedge fund strategies)

• Emphasize liquid strategies

• Decrease strategies with material balance sheet/basis risk

• Minimize short volatility and crowded strategies

• Emphasize manager flexibility (e.g., ability to nimbly rotate between “risk on” or “risk off” postures)

• Preemptively terminate managers who may be performing, but who could be subject to material declines and outsized withdrawals in a market correction

• Shorten our liquidity duration—i.e., increase the amount of look-through capital available over shorter periods for our FOF portfolios and decrease the percentage of capital committed for longer periods—allowing us to rotate capital quicker as opportunities from dislocations surface

Hedge Fund Strategy Outlook —Current “Heat Map”Today’s environment mandates a balance between return and risk management considerations, and a correspondingly high-er weight to strategies with attractive risk variables given the potential for pockets of volatility. As such, we view the most attractive strategies as those that we expect to be less corre-lated, as well as strategies that have the chance to perform in higher volatility regimes. Less attractive are strategies that are spread based, carry significant directionality, or that are dependent on events/catalysts associated with stable markets (e.g., robust M&A activity). Exhibit 3 is a complete listing of each hedge fund strategy rank.

Outlook By Strategy

Opportunistic/MacroIn this strategy managers trade opportunistically across markets, and exhibit a great deal of flexibility in their security selection or portfolio positioning. Overall the sub-strategy ranked the highest within this classification is reinsurance. Traditional macro managers who focus primarily on rates and currencies, and rely on fundamental economic assumptions in expressing their views/trades rank fairly high as well (Exhibit 4).

Source: J.P. Morgan Asset Management. As September 30, 2011.

EXHIBIT 2: HISTORICAL RATINGS SINCE 2ND QUARTER 2008

Return Risk Return Risk

Q3 11 3 4 Q4 09 2 3

Q2 11 2 4 Q3 09 1 3

Q1 11 2 3 Q2 09 1 4

Q4 10 2 3 Q1 09 1 5

Q3 10 2 3 Q4 08 2 5

Q2 10 2 3 Q3 08 3 4

Q1 10 2 2 Q2 08 3 3

J.P. Morgan Asset Management | 3

EXHIBIT 3: HEDGE FUND STRATEGY RANK AND HEAT MAP


Rank Strategy Sub-Strategy

Factor 1 Factor 2 Factor 3 Factor 4Heat map

Score

X % X % X % X % 100%

1 Opportunistic/Macro Reinsurance

FACTOR WEIGHTS AND SCORES FOR EACH STRATEGY ARE PROPRIETARY.

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2 Relative Value Statistical Arbitrage / Quantitative

3 Relative Value Managed Co-invest

4 Relative Value Commodities RV

5 Relative Value Volatility Arbitrage

6 Opportunistic/Macro Macro

7 Opportunistic/Macro Quantitative / Short-term CTA

8 Credit ABS-Mortgage

9 Relative Value RV Credit

10 Credit Corporate-Distressed

11 Credit Corporate-Litigation/Liquidation

12 Long/Short Equities Activist

13 Long/Short Equities Low to Mid Net

14 Merger Arbitrage/Event Driven Multi-Event Driven

15 Relative Value Nimble Multi Strat / Niche

16 Opportunistic/Macro Commodities

17 Long/Short Equities Aggressive Net

18 Long/Short Equities Flexible Net

19 Merger Arbitrage/Event Driven Merger Arbitrage

20 Opportunistic/Macro Emerging Markets

21 Credit Corporate-Capital Structure

22 Credit ABS-Esoteric

23 Relative Value Equity Market Neutral

24 Relative Value Multi-Strategy

25 Relative Value Convertibles

26 Long/Short Equities Post Bankruptcy Equities

27 Credit Corporate-Performing HY

28 Relative Value Asia RV / Event

29 Credit Direct Lending

30 Portfolio Hedge Equity Tail Hedge

31 Portfolio Hedge Credit Hedge

32 Portfolio Hedge Short & Short Bias Equity

EXHIBIT 4: OPPORTUNISTIC/MACRO STRATEGY RANK AND HEAT MAP




Score

X % X % X % X % 100%

1 Opportunistic/Macro Reinsurance


6 Opportunistic/Macro Macro

7 Opportunistic/Macro Quantitative / Short-term CTA

16 Opportunistic/Macro Commodities

20 Opportunistic/Macro Emerging Markets



Reinsurance1

We believe that reinsurance as a hedge fund strategy can offer investors uncorrelated returns that complement their overall asset allocation scheme. Further, given the current dynamics within the reinsurance space following the natural disasters in 2010/2011, attractive returns are more likely now than they have been in a number of years.

What is Reinsurance?Reinsurance is quite simply insurance for insurance compa-nies, allowing insurance companies to cap their exposure to specific events, regions, and/or industry losses. The goal of an insurance company is to write risk for a diversified pool of exposures in order to generate overall positive net premiums (i.e., total premiums received less total claims paid). However, when a major catastrophe occurs, an insurance company can

be subject to losses since the losses can quickly erode the company’s capital base. Reinsurers, whether large companies (e.g., Lloyds, Munich Re, Swiss Re, etc.) or hedge funds, allow insurance companies to limit their losses and focus on writing coverage for a diverse set of possible claims. In this short paper we summarize how hedge funds participate in the rein-surance market, and why the opportunity set has improved.

What are the benefits of investing?As a hedge fund strategy, reinsurance can offer attractive returns that are uncorrelated with the broader markets and other hedge fund strategies. Exhibit 5 shows return and corre-lation statistics for the Swiss Re catastrophe bond index. The returns for these bonds are moderately representative, but overall we expect the returns for a portfolio of reinsurance hedge funds, employing a diverse set of contracts and struc-tures to be far more attractive.

1 For a more detailed review of the reinsurance marketplace and how hedge funds are poised to participate, please contact your J.P. Morgan representative, or a member of J.P. Morgan Alternative Asset Management (regional contacts are listed at the front of this paper).

EXHIBIT 5: RETURN AND CORRELATION STATISTICS FOR THE SWISS RE CATASTROPHE BOND INDEX

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

Annualized returns (October 2002–September 2011)

1 year (%) 3 year (%) 5 year (%) 10 year (%)

Swiss RE BB Cat Bond Index 3.54 7.95 6.89 6.39

HFRI Fund of Funds Index -1.59 0.22 -1.96 3.35

HFRI Fund Weighted Composite Index 0.32 4.58 1.01 6.34

S&P 500 1.14 1.23 -4.08 5.20

Barclays Capital US Aggregate Bond Index 5.26 7.97 5.99 4.80

JPMorgan Global High Yield Index 2.55 13.50 5.37 8.97

S&P GSCI Total Return Index 2.87 -15.90 -5.06 2.18

10-year correlations (October 2002–September 2011)

Rank

Swiss RE BB Cat Bond

Index

HFRI Fund of Funds

Index

HFRI Fund Weighted

Composite Index S&P 500

Barclays Capital US Aggregate

Bond Index

JPMorgan Global High Yield Index

S&P GSCI Total Return

Index

Swiss RE BB Cat Bond Index 1.00

HFRI Fund of Funds Index 0.28 1.00

HFRI Fund Weighted Composite Index 0.26 0.96 1.00

S&P 500 0.22 0.66 0.80 1.00

Barclays Capital US Aggregate Bond Index 0.26 0.01 0.02 0.02 1.00

JPMorgan Global High Yield Index 0.30 0.67 0.74 0.69 0.22 1.00

S&P GSCI Total Return Index 0.12 0.59 0.57 0.35 0.00 0.38 1.00


Is now a good time to invest?There was a material increase in the number and scale of nat-ural disasters in 2010 and 2011. This caused reinsurance com-panies to increase the premiums they charge to insurance companies, since they have in many instances exhausted their budgeted losses, and seen a significant decrease (or an overall loss) on their net premiums (gross premiums received less claims paid) for the period (Exhibit 6).

The result on a looking forward basis is a re-pricing of the net premiums that reinsurers are demanding to cover a variety of perils, with U.S. wind net premiums seeing perhaps the greatest increase (the amount of coverage written on U.S. wind exceeds most other peril classifications by a significant margin). Exhibit 7 outlines the January 2012 pro forma return on capital distribution for an actual hedge fund. The line assumes various loss scenarios as the multitude and severity of claims increases to arrive at projected returns in a given year. Based on today’s pricing/premium levels, in 75% of years the returns will be 17.1% or more. This return distribution for the strategy is more attractive than it has been in a number of years.

EXHIBIT 6: INSURED LOSSES TO NATURAL DISASTERS IN 2010 AND 2011

JapanTohoku Earthquake: $35 billion United States

Hurricane Irene: $6 billionTornadoes: $19 billionThailand

Floods: $15–$20 billion

AustraliaFloods: $6 billion

New ZealandEarthquakes: $12 billion (and rising)

Source: J.P. Morgan Alternative Asset Management, December 2011.

EXHIBIT 7: JANUARY 2012 PRO FORMA RETURN ON CAPITAL DISTRIBUTION FOR AN ACTUAL HEDGE FUND

Source: J.P. Morgan Alternative Asset Management and undisclosed hedge fund.

Retu

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)

Cumulative probability (%)

30

20

10

0

-10

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0 10th 20th 30th 40th 50th 60th 70th 80th 90th 100th

-60

-70

-8099.6th; -74.7

99th; -58.5

98th; -46.1

95th; -24.5

90th; -3.1

75th; 17.1

25th; 24.1

Median/50th; 23.4 Mean; 15.8



Traditional MacroMacro managers tend to do better in environments where pol-icy actions and the corresponding changes in rates, curren-cies, markets, etc. are not as predicable. The best indicator of this is often when a dispersion of sentiment and predictions occurs between economic thinkers. For instance, Exhibit 8 shows the historical forecasts for price changes within the Euro Area. As seen, the dispersion is increasing as of late, and managers who accurately predict the actual changes in rates and currencies can differentiate themselves. Importantly, even the best managers are only correct a little more than half the time, so disciplined risk management is critical.

Additionally, macro managers have historically exhibited low correlation levels, participate in the most liquid instruments (futures, currencies, etc.), and have a propensity to quickly increase risk or decrease risk based on the environment (i.e., risk on vs. risk off), making the strategy attractive in this vola-tile market environment.

Relative Value

Traditional vs. NicheTraditional relative value managers focus on technical pricing dislocations between related securities. Overall the strategy remains under pressure due to low interest rate environment, although recent market volatility may lead to more opportuni-ties. The ability to obtain leverage and borrow (for shorting) is fairly robust, a positive for the strategy. As shown in Exhibit 9, among traditional relative value managers, statistical arbi-trage and quantitative strategies rank very high.

Niche relative managers focus on very narrow market seg-ments, or bring a more active style to sourcing and managing their ideas. Niche strategies are somewhat better insulated from pressures of low rates. Current market turmoil should increase the “flow-driven” dislocations/opportunities. Our managed co-investment program (which although classified as a strategy in our heat map rankings is a more accurately described as a diversified series of very unique trades) ranks the highest, with commodities relative value also very attractive (Exhibit 10).

EXHIBIT 9: TRADITIONAL RELATIVE VALUE STRATEGY RANK AND HEAT MAP




Score

X % X % X % X % 100%2 Relative Value Statistical Arbitrage / Quantitative


15 Relative Value Nimble Multi Strat / Niche23 Relative Value Equity Market Neutral24 Relative Value Multi-Strategy25 Relative Value Convertibles28 Relative Value Asia RV / Event

EXHIBIT 10: NICHE RELATIVE VALUE STRATEGY RANK AND HEAT MAP


EXHIBIT 8: EURO AREA CONSUMER PRICE % CHANGE FORECASTS

Source: The Economist poll of forecasters: BOA, BNP, Citi, Commerzbank, Decision Economics, DB, Economist Intelligence Unit, GS, HSBC, ING, J.P. Morgan, KBC, Morgan Stanley, RBS, Schroders, Scotiabank, Societe Generale, Standard Chartered, UBS.

3.0

2.5

Perc

ent c

hang

e

2010 2011

2.0

1.5

Mar

Apr

May Jun

Jul

Aug

Sep

Oct

Nov Dec Jan

Feb

Mar

MayApr Jun

Jul

Aug

Sep

Oct

Nov

1.0

0.5

0

High

Average

Low



Score

X % X % X % X % 100%3 Relative Value Managed Co-invest


4 Relative Value Commodities RV5 Relative Value Volatility Arbitrage9 Relative Value RV Credit


Statistical Arbitrage/QuantitativeThere are no useful charts or graphs to illustrate why such managers are attractive today; rather, we rely on our qualita-tive assessment here in the ranking. Generally, we like the strategy today for several reasons. The strategy tends to be very liquid, as managers primarily trade equities with suffi-cient volume to support their high frequency/short holding period style. Managers are very hedged and exhibit minimal or no directional biases (often trading pairs of stocks/baskets anticipating a mean reversion to a historical relative pricing level), so they are less susceptible to market volatility and can exhibit low correlation levels.

There are tremendous barriers to entry, since an effective quantitative manager needs scale to cover the cost of sophisticated systems and quantitative professionals/traders; from a strategy viewpoint this attribute is appealing because minor dislocations that surface are more likely to be screened and quickly capitalized vs. smaller, less sophisticated, and slower would-be participants who are not able to act quickly enough. This attribute is especially appealing today, as the upticks in volatility that we have experienced recently will result in more relative pricing dislocations to exploit and hopefully attractive performance.

Commodities Relative ValueThe strategy is attractive as it fits nicely with our preferences driven by the macro environment, and also given the pockets of current opportunities that have surfaced within the strate-gy. Below are several of the reasons why we have a positive view on the strategy:

• Futures and options contracts have very good liquidity.

• Managers are not forced to take a directional view on commodities (and do not have to participate in the corres-ponding volatility), and can potentially generate returns that are uncorrelated.

• Flexibility: There are a multitude of uncorrelated arbitrage type positions that can be employed, allowing managers to select the most attractive relative value opportunities, such as being long and short different related commodities (e.g., aluminum vs. copper), different classes of the same commodity (e.g., hard wheat vs. soft wheat), different settlement dates for the same commodity (e.g., near term contracts vs. long term contracts—“calendar spreads”), different volatility pricing levels (e.g., the implied volatility of

different options contracts referencing a commodity will differ), and/or different delivery hub locations (e.g., the price for natural gas in the Northeast United States may be different than in the United States Mountain region).

• Managers continue to have informational advantages from the physicals markets—in other words, managers can act as both a merchant and a trading firm, using the insights they gain from receiving and delivering physical commodities as the basis for investing within their hedge funds. Considering that current market turmoil has increased the flow-driven dislocations/opportunities, having such insight can be an advantage.

ExamplesExhibit 11 shows the spread between wheat and corn prices for the nearest settlement month. Typically wheat trades above corn as it has a higher protein content, but recently the relationship has inversed, driven by supply/demand imbalances that occurred in 2011. A number of managers we invest with view as a technical dislocation that is likely to reverse. Obviously we hope that they are correct, but regardless, we feel quite confident that the spread between corn and wheat will be fairly uncorrelated with the markets and other hedge fund strategies, and this is one reason why this strategy is particularly attractive given the current environment.

Similar to corn and wheat, the price relationship between crude oil sourced from the North Sea (Brent) and from North America (WTI) has varied considerably this past year, with Brent outpacing the price of WTI, and with the spread collapsing over the past few months. One reason why WTI lagged was driven by bottleneck of distribution of WTI crude from Cushing,

EXHIBIT 11: PRICE SPREAD—WHEAT LESS CORN (ROLLING FRONT MONTH)

Source: Bloomberg. Data as of January 6, 2012.

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CreditThe potential return for credit managers has improved (Exhibit 13), and we view the risk/return proposition as moderately attractive.

Managers have recently found a wide array of attractive situations, and we expect supply to increase considerably in the months ahead. Almost 20% of the high yield bond universe now trades at distressed levels (spread of >1,000bp). However, liquidity is a larger risk today. Since the summer of 2011, dealers have been reducing inventory as they are wary about taking risk; this has caused bid/ask spreads to widen as there were few two-sided markets in many names making it difficult for managers to add/reduce positions. Of the credit oriented strategies, we view ABS-mortgage as the most attractive sub-strategy (Exhibit 14).

Oklahoma (which is the primary delivery and storage location of WTI in the United States) following the closing of a large pipeline distributing WTI from Cushing and a concurrent increase in the supply of oil flowing into Cushing from Canada and North Dakota. The overhang of supply and lack of an abili-ty to distribute caused the price of WTI to fall well below that of Brent. Hedge fund managers who participate in the busi-ness of drilling, refining, and distributing oil have a better gauge on whether there will be new distribution facilities that come on line, which would allow for a release of the oversup-ply in Cushing and bring the relationship between WTI and Brent back to a range bound parity. As with Wheat/Corn spreads, managers positioning for the price of “oil” are less attractive than those with a view to trade the relationship between types of oil, both due to the ability to really have an edge in trading the relationship and the fact that price spreads are likely to exhibit low correlation aspects (Exhibit 12).

EXHIBIT 12: CRUDE OIL CONTRACT SPREAD* (ROLLING FRONT MONTHS)

Source: Bloomberg as of January 6, 2012.

* Brent (North Seas) less West Texas Intermediate.

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EXHIBIT 13: POTENTIAL RETURN FOR CREDIT MANAGERS

Source: J.P. Morgan. Data as of January 2012.

20-year average = 585 bp20-year median = 517 bp

Dec ’081,925 bp

Sep ’021,070 bp

Dec ’901,096 bp Jan 5, 2012

738 bp

Spre

ad to

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st (b

asis

poi

nts)

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87Ja

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EXHIBIT 14: CREDIT STRATEGY RANK AND HEAT MAP




Score

X % X % X % X % 100%

8 Credit ABS-Mortgage


10 Credit Corporate-Distressed

11 Credit Corporate-Litigation/Liquidation

21 Credit Corporate-Capital Structure

22 Credit ABS-Esoteric

27 Credit Corporate-Performing HY


ABS MortgageIn the non-agency RMBS space, managers are finding invest-ments with attractive risk reward characteristics. These securi-ties tend to be relatively short duration, cash flowing, and with several years of borrower history. Very often over half of the loans from the original pool have already been liquidated. This process of “credit burnout” can improve the characteristics of the remaining pool and make future cash flows more depend-able. Exhibit 15 shows several estimates of the returns that may be generated based on certain assumptions.

In a bear case scenario, with very elongated liquidation time-lines and worsening severities, managers expect certain Alt-A RMBS securities to generate a 5% yield. In the base case, in which both severities and liquidation timelines extend modestly, these securities are expected to generate 10% yields. Under a reasonable bull case in which home prices stabilize and liqui-dation speeds eventually increase, mortgage cash flows should generate a 13% return.

In many cases Alt-A securities enjoy further upside optionality from so-called “put backs.” This occurs when an originator repurchases a mortgage from an investor holding a RMBS security. The investor must show that the originator has violated one or more reps and warranties made to the trust at the time the security was issued. Put backs could reasonably add 5–6 percentage points to the yield on these bonds. All of the yields quoted above are on a loss adjusted basis, i.e., after all losses

on defaults are accounted for. Even adjusting for future losses, the yields tend to be more attractive than corporate credit, with high yield bonds currently offering a yield of around 8.5%.

Long/Short EquityAs illustrated in Exhibit 16, correlations continue to be near or at historical highs. This is making for a difficult environment for long/short equity managers, as it is more challenging to add alpha through stock selection when stocks all move in tandem.

However, there is still the potential to generate attractive returns as a long/short equity manager from spreads/biases to a variety of variables. For instance, in 2011 the average return for cyclical companies was -3.3%, while the average return for defensive companies was +13.2% (according to Standard and Poor’s sector indices); additionally, the average return for the top 20% of companies based on quality (based on a variety of metrics such as financial health and competi-tive position, as measured by BofA Merrill Lynch) was +9%, while the lower 20% of companies based on quality returned -26%. Managers who over- or underweighted the appropriate factors had success in 2011 and performance in 2012 could again be driven by factor choices rather than stock picking.

EXHIBIT 15: POSSIBLE RMBS YIELDS


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18

Bear Case Base Case Bull Case “Put Back”

EXHIBIT 16: LONG/SHORT EQUITY MANAGER CORRELATION

Source: BofA Merrill Lynch, HFR, Bloomberg. As of December 31, 2011.

1986

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200

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80 Clustered/macro marketCurrent

Differentiated/stock picker’s market

Long-term average



Overall, a macro driven market and high correlations lead us to be neutral on equity long/short as a strategy. As Exhibit 17’s ranking of long/short equity sub-strategies illustrates, the highest ranking sub-strategy, “Activist,” ranks only as high as 12.

ActivistsActivist managers are subject to the movements of equity mar-kets given their propensity to be long only and concentrated in companies they intend to transform. We have a very positive view of an activist’s ability to use an extensive “tool kit” to unlock value in the companies they own. Over time managers have proven that taking an active approach to change compa-nies through operational, strategic, or financial initiatives can unlock value, and allow for significant outperformance com-pared to a passive equity investment portfolio. In an environ-ment where growth is slow, companies have accumulated cash, and valuations are somewhat depressed, an activist can play a role in driving management to unlock value—this is why the strategy ranks the highest among equity long/short strategies. However, compared to other equity long/short strategies activ-ists have less liquidity; they are typically very concentrated in perhaps 10–15 stocks, and often restricted from freely transact-ing in the stock given their insider or controlling status. Considering this, as well as today’s equity market volatility and the strategy’s relatively high beta, its rank has declined to 12th from as high as 4th in June of 2011.

Merger Arbitrage/Event DrivenAs seen in Exhibit 18, event driven and dedicated merger arbi-trage strategies currently rank 14th and 19th, respectively, as the environment is providing few opportunities for managers to build a diversified portfolio; this is especially true for larger managers who are less nimble, and who over the past year were increasingly shifting away from hard event to soft event or even value equities in order to stay fully invested (which had a negative impact on a number of managers in 2011).

The active supply of deals is low to moderate, as M&A activity slowed substantially in the second half of 2011 with the increase in volatility. There is a decent pipeline of activity for event managers, such as anticipated stock offerings, spin-offs, divestitures, etc. which may serve as a potentially attractive backdrop for the strategy. However, the volatility and the variety of uncertainties surrounding policymaker decisions (and who will be the policy makers in 2103) are making it challenging for companies to move forward with their plans to acquire, recapitalize, restructure, etc.—this is despite the fact that corporate America is holding a great deal of cash (Exhibit 19, next page).

EXHIBIT 18: MERGER ARBITRAGE/EVENT DRIVEN STRATEGY RANK AND HEAT MAP




Score

X % X % X % X % 100%

14 Merger Arbitrage/Event Driven Multi-Event Driven FACTOR WEIGHTS AND SCORES FOR EACH STRATEGY ARE PROPRIETARY. 19 Merger Arbitrage/Event Driven Merger Arbitrage

EXHIBIT 17: LONG/SHORT EQUITIES STRATEGY RANK AND HEAT MAP




Score

X % X % X % X % 100%12 Long/Short Equities Activist


13 Long/Short Equities Low to Mid Net17 Long/Short Equities Aggressive Net18 Long/Short Equities Flexible Net26 Long/Short Equities Post Bankruptcy Equities


deals with “hair”, and often these deals are hostile or unsolicited. Assuming that managers gravitate towards these deals, then the risk of the strategy increases. If last year is any indication of how things will play out this year, then managers will need to be careful. As seen in Exhibit 21, in 2011 the total termination rate for unsolicited deals was 61%, up from 46% the year before and a historical average of around 52%. Most of the terminations were unfavorable (i.e., not due to topping bids or bumps).

Given the above backdrop, we are neutral to negative on merger arbitrage, and slightly more bullish on event. We favor activist event managers, ideally smaller in size, who have the ability to control some of the event process or the skills to more tightly hedge event driven special situations or soft event trades.

SummaryWe hope that this paper was informative. Each month we rebalance our portfolios to reflect any updates to our strategy views, as well as to include or exclude managers within each strategy. If you would like additional details on the underpin-nings of our approach, we are available to discuss the rigorous process that we undertake to formulate our views and build our model portfolios, and to demonstrate the proprietary technology that we use in our portfolio construction process.

Of the active deal universe that does exist today, returns/spreads have become moderately attractive (Exhibit 20, which shows historical spreads for North American deals), which is a positive. We believe that the spreads are just as much a reaction to the volatility from the European debt crisis as widespread risks embedded in the deals. Further, the amount of capital from arbitrageurs has decreased, especially as European bank proprietary capital has exited the strategy (with no sign that it will return any time soon), so it may remain attractive for some time.

What concerns us today is the fact that the list of mid-to-large cap deals is short, leading to hedge fund crowding in these positions. It results in higher “deal break” risk for hedge fund investors. The most attractive returns (i.e., spreads) are in

Source: Barclays Capital.

EXHIBIT 21: TERMINATION RATES BY DEAL TYPE

Initially unsolicited (%) Initially definitive (%)

Complete 39 94

Terminated 61 6

Unfavorable 29 1

Favorable 19 5

Ambiguous 13 0

EXHIBIT 19: CORPORATE CASH AS A PERCENTAGE OF CURRENT ASSETS—S&P 500 COMPANIES, CASH AND CASH EQUIVALENTS, QUARTERLY

Source: J.P. Morgan Asset Management. Data as of January 6, 2012.

’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’09 ’11’08 ’10

Perc

ent

14

16

18

20

22

24

26

28

30

EXHIBIT 20: HISTORICAL SPREADS FOR NORTH AMERICAN DEALS

Source: Barclays Capital. Data as of January 2012.

’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’09 ’11’08 ’10

Perc

ent

0

5

10

15

20

25

30 Ann. spread

LIBOR adj. ann. spread


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