Hedge Funds: Inside the Buyer’s Head

1. Hedge Funds: Inside the Buyer’s Head Robert A. Jaeger, Ph.D. March 21, 2005

2. Motives for Investing • Potential for • Attractive absolute return • LIBOR plus 3% to 8%, depending on risk tolerance • Volatility lower than standard equity benchmarks • Low correlation with standard markets, especially in down markets

3. Issues • Sources of return and risk • Leverage, short selling, and taxation • Performance fees • Transparency • Capacity: is there a hedge fund bubble?

4. Major Hedge Fund Categories Relative value: long vs. short positions, minimal net market exposure. Event-driven: net long bias, emphasizing specific corporate transactions (mergers, acquisitions, reorganizations, etc.) likely to produce definable changes in value within a definable period (typically 3-12 months). Equity hedge funds: “micro” investors focused on stock selection and company analysis, enhanced with ability to use leverage and sell short. Global asset allocators: “macro” investors who can be long, short or neutral with respect to multiple markets (interest rates, currencies, equity indexes, commodities). Short sellers: net short, usually focused on US equities, designed as hedge against down markets. More Risk Less Risk

5. Historical Risk/Return Characteristics 1995 – 2004:October Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1990 – December 2003) and EACM100® Index – Offshore Funds (January 2004 – October 2004.) See www.eacm.com for more information regarding the EACM100® Index.

6. Performance in S&P 500 Negative Months 1995 – 2004:October US Equity (S&P 500 Composite) was down 38% of the months, with an average monthly loss of 4.0%. Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1990 – December 2003) and EACM100® Index – Offshore Funds (January 2004 – October 2004.) See www.eacm.com for more information regarding the EACM100® Index.

7. Two Kinds of Strategies • Many hedge fund strategies employ “enhanced active management”: traditional active management enhanced with short selling, leverage, and other techniques. For example: • Market neutral equity • Fixed income arbitrage • Equity hedge funds • Global macro investing • Some hedge fund strategies are genuinely distinctive, not based on traditional techniques. These strategies are important sources of liquidity for financial markets. • Convertible hedging • Risk arbitrage • Distressed debt

8. How Do Hedge Funds Make Money? • Hedge funds make money the old-fashioned way: they take risk. • Beware of common stories that underestimate risk: • “They exploit market inefficiencies” – not enough to go around • “They supply liquidity to markets” – some do, some don’t • “They take advantage of manager skill” – hedge funds have no monopoly on manager skill

9. Risk Factors • General risks • Leverage • Concentration • Illiquidity • Market-related risks • Directional market risk • Non-directional systematic risks, e.g., • Equity: long value vs. short growth, long small cap vs. short large cap • Fixed income: carry trades: long higher risk vs. short lower risk • Exposure to volatility and “trendiness” • Organizational risks • Small shops, smaller asset bases, shorter records • Blow-up risk, headline risk

10. Leverage, Short Selling, and Taxation • Short selling is sometimes designed to reduce risk, sometimes designed to enhance return, sometimes both. • Leverage definitely increases risk, may or may not increase return. • Leverage can create Unrelated Business Taxable Income (UBTI) for tax-exempt investors. The use of offshore funds generally avoids UBTI.

11. Performance Fees • Most hedge funds charge a combination of asset-based and performance-based fees, often 1% plus 20%, or more. • Performance fees grant the hedge fund manager a “free call option” on the fund’s performance, may create an incentive to take incremental risk.

12. Transparency • Hedge funds generally offer much less transparency than traditional separately managed accounts. • Many institutional investors are overly obsessed with transparency, failing to distinguish between • Daily position and transaction reports and • Useful portfolio information

13. Capacity and Bubbles • Some common estimates: • 7,000 – 10,000 hedge funds • 1,000 fund of funds • Total assets $800 billion - $1 trillion • Steady growth in recent years, driven by weaknesses in traditional markets, concerns about rising interest rates • Is there too much money chasing too few opportunities? Important to separate homogeneous strategies from heterogeneous strategies. • Homogeneous: Managers tend to “herd” around similar positions,e.g., convertible hedging, risk arbitrage, distressed debt. • Heterogeneous: Wide divergence among manager positions, e.g. equity hedge funds, global asset allocators. • Capacity issues are more pronounced in homogeneous strategies.

14. 2004 Performance Most funds of funds target a net return of LIBOR plus 3%-8%. Returns in 2004 were at the low end of the range. Some returns are based on preliminary results and subject to change.

15. Performance by Strategy 2004 Annual Return % Source: EACM Advisors LLC

16. Low Volatility • Equity market volatility has been very low, both at the index level and the individual stock level. This applies both to implied and realized volatility. • Low volatility is particularly hard on convertible hedging, but also hurts other strategies that depend on price movements for trading profits. Implied Index and Stock Volatility Historical Index and Stock Volatility Source: Citigroup/Smith Barney and Chicago Board Options Exchange

17. Low Dispersion of Returns • Hedge funds need stocks to display differences in return, but dispersion is at historically low levels. Historical Cross-Sectional Stock Volatility Source: Citigroup/Smith Barney and Chicago Board Options Exchange

18. Did Hedge Funds Cause these Problems? • Hedge funds are clearly not the cause of low short term interest rates. • Do hedge funds cause low volatility and low dispersion? No – they would do this only if hedge funds, in aggregate, pursue contrarian trading strategies that act as a negative feedback loop in the markets. In fact, many hedge funds are more momentum-oriented, acting as a positive feedback loop. • Several years ago, hedge funds were blamed for adding to market volatility. You can’t have it both ways.

19. Heterogeneous Strategies • Many hedge fund strategies are extremely heterogeneous, especially: • Equity hedge funds • Global asset allocators • Diversity holds at two levels: • Setting up the position • Managing gains and losses • Most hedge funds tend to cut losses quickly • Some hedge fund managers like to add to winning positions, others are quicker to take profits.

20. Heterogeneity in Action Stock up Stock down Buy Sell Sell Sell Long Position Builder Trimmer Short Position Builder Trimmer Buy Buy Sell Buy Beware of glib generalizations about “what the hedge funds are doing.”

21. Two Final Thoughts • Many people think that hedge funds make money by identifying inefficiencies and anomalies. On this view, the growth of the business means that the inefficiencies will get “arbed away.” But most hedge funds do not make money by seeking inefficiencies. • Be careful about database returns and index returns. Our basic suspicion is that hedge funds, in aggregate, do not make money. Manager selection and strategy diversification are the keys to success. Hedge fund investing is like venture capital investing: the performance of the median fund is not compelling, but a well-managed portfolio can provide excellent risk/return properties.