Milano, Palazzo Turati June 7, 2007

1. “Successful investing is anticipating the anticipations of others” “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally” John Maynard Keynes Alberto Di Stefano (CEO) - Thalia SAEmotions as a Source of Alpha: The Example of Hedge Fund Managers Milano, Palazzo Turati June 7, 2007

2. Emotions: Limits and Opportunities • Investors think rationally but often act irrationally • The analysis of emotions and investor behavior plays a crucial role in a successful investment decision • Emotions may prevent investors from taking objective investment decisions limiting their ability to invest successfully • Taking into proper consideration the main behavioral biases may potentially represent a source of alpha

3. Be aware of the limits • It is important to strive to be as objective as possible • The more objective a research analyst is the more likely that good risk/reward investment decisions are made • Being a stock picker is something more than being a simple stock researcher. Strong analytical and academic skills must be coupled with the ability to make/communicate objective decisions • A successful investment company should facilitate an objective investing environment

4. Be aware of the limits • A rigorous methodology is crucial to being objective investors • Methodology provides the right level of confidence to the research analysis. Confidence is essential for making positions larger and for sticking with positions which may be performing poorly for temporary reasons, whether fundamental or non-fundamental • Methodology gives you a way to face a changing market environment and contextualize new pieces of information • Better habits make better analysts

5. Analyst Bias* The analyst may: • Hesitate to change his view right after a stock recommandation, ignoring new information flow for the fear that a change might be confused with a poor level of convinction on the idea • Have previously had a bad experience with the stock. That may prevent from him/her being completely objective in the research analysis • Become complacent with a stock recommendation, believing he ‘knows all there is to know’ and ending up unfairly weighting certain facts to support a conclusion more consistent with his previous view • Become less confident to recommend another stock after a recent stock disappointment * Various Meetings with Hedge Fund Managers

6. A way to prevent analytical bias*: Expected Outcome • When calculating the price target for a stock some managers utilize an ‘expected outcome calculation’ by considering multiple scenarios (upside, base and downside) • For the less confident analysts it is less stressful than a more direct evaluation since they are not forced to make a precise ‘call’ • Overconfident analysts are forced in this way to consider the downside scenario and acknowledge the probability it will materialize • The evaluation of the upside scenario compels the analyst to understand who will be his final buyer. * Various Meetings with Hedge Fund Managers

7. A way to prevent analytical bias*: Sizing • Sizing of positions is a valuable approach to maintain objectivity and remove emotions from the decision making process. It is especially useful in periods of market dislocation, when the ‘opportunity/cost of emotions’ is definitely much higher • There are three primary inputs necessary: • The expected outcome of the stock • The level of conviction on the idea • The volatility of the stock • Once the trade is implemented, traders monitor the target size and ‘alert’ the analysts/CIO to add when the stock falls below target and to trim when it approaches the target * Various Meetings with Hedge Fund Managers

8. Preventing analytical bias*: Make communication more objective • There is a natural tendency to put the highest weighting of importance on the most recent piece of information received without contextualizing it – ‘Immediacy Bias’. The risk is heightened during stressful times or the middle of trading hours • If someone has a material piece of information to share regarding a stock, it is a good practice to step back and review the opinion on the stock, putting into context the importance of the new information and discussing to what extent it may alter the conviction on the stock • This simple protocol allows for a more disciplined and objective investment approach * Various Meetings with Hedge Fund Managers

9. Three Sources of Alpha* Exploit Information Exploit Behavior Better Model Quantitative Managers assume that most information is publicly available but processed inefficiently. They look for procedures/models for processing the information better Behavioral Managers try to exploit common behavioral biases in processing financial information and systematic mental mistakes by modeling effective and uncorrelated investment strategies Traditional Managers try to generate alpha building up a better information set (proprietary earnings forecasts, better understanding of the economics underlying a particular industry, privileged information) * Russel Fuller, Behavioral Finance and the Sources of Alpha, BSI GAMMA Foundation, Lugano June 2000

10. Hedge Fund Managers • Whatever may be their investment style and risk return profile, hedge fund managers aim for positive absolute returns. In the case of Long/Short equity in particular, this is often to capture market upside and achieve capital protection in bear markets • A well managed Hedge Fund is at heart simply a portfolio with a low or zero beta and a (hopefully) high expected alpha • Getting positive absolute returns is not magic but is a matter of skill in selecting the most profitable investment opportunities and in adapting the investment style to the changing market environment, whatever may be the reason for the change (rational or irrational) • Being aware of potential behavioral biases is crucial to producing positive returns during periods of “market irrationality” • The evaluation of a manager’s ability to read the market environment and to adapt investment decisions accordingly is a crucial part of a hedge fund due diligence process

11. Conclusions • Attempting to achieve alpha requires the ability to adapt the investment style to a changing market scenario • Success requires meeting the two conditions of • Inefficiency in the relevant markets • Skillful selection of investment positions • Some hedge fund managers exploit behavioral finance models as an active source of alpha. This must be taken into consideration when constructing a portfolio of hedge fund investments as a potential source of diversification • Talented hedge fund managers take into proper consideration both the opportunities and limits provided by investors’ emotions • Although it is not necessarily an explicit part of their investment process, most hedge fund managers consider emotions or behavioral tendencies when making investment decisions. The more experienced managers also use it for risk monitoring purposes

12. Sources • Various contributions from hedge fund managers • ‘Behavioral Finance and the Sources of Alpha’, Russell J. Fuller, June 2000 • ‘Emotional Rescue’, J.K.Glassman, National Review Online • ‘What is Behavioral Finance?’, An interview with Meir Statman, IMCA Interviews, May/June 2005 • ‘The Human Investor: Dreams & Nightmares’, Fundamental psychological insights and the European equity investment process, JPMF European Equity Group, Q2 2002