A subset of alternative investments that incorporate all investment strategies run with an orientation to producing primariloy absolute returns using largely marketable securities

A private and unregisterd investment pool that employs sophisticated hedging and arbitrage techniques to trade in the corporate equity markets

“Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their inestors redeem and go to someone else who has recently been making money. Every three or four years, they deliver a one-in-a-hundred-year flood.”

The first hedge fund was set up by Alfred W. Jones 1949 Used short sales, leverage and fees Converted from general partnership to limited

partnership in 1952 Publicized in 1966 in article in Fortune magazine

Growth from 1986-1993 and following collapse of tech bubble in 2002 Hedge funds did relatively well in 2000 - 2002

Size has been doubling almost every two years

One measurement of 11,000 active funds in 2008

$2.4 Trillion under management (various measurements)

Account for 30% of all U.S. fixed-income trading 80% for distressed debt and high-yield

derivatives

Do not fall under the Investment Company Act No public offerings Limited number of investors

Do not fall under Securities Act of 1933 Only “accredited investors consisting of

institutional investors, companies, or high net worth individuals who can ‘fend for themselves’”

Not required to disclose their holdings to investors

Not required to report investment results May not advertise Limited partners must have already

formed a relationship with the general partner

Allowed to use leverage Usually 2:1 to 10:1 LTCM was 500:1 by one report

Limited Partnership or Offshore Corporation

Collection of funds (feeder funds) Each fund designed to optimize taxes for a

group of investors Offshore fund for foreign investors and

onshore fund for U.S.-taxed investors

Location Percent Assets

Cayman Islands 35%

United States 32%

British Virgin Islands 8%

Bermuda 8%

Bahamas 4%

Luxembourg 3%

Asia 4%

Manager usually has high percentage of his/her assets invested in fund

Current trend towards more institutions investsing in hedge funds Proportion of institutions to individuals is

increasing

Asset Class Percent Allocation

Equity 51%

Fixed Income 17%

Real Estate 4%

Hedge Funds 15%

Private Equity 3.2%

Venture Capital 3.5%

Natural Resources 3%

Source: NACUBO Endowment Study

Convertbile Arbitrage Merger Arbitrage Long/Short Dedicated Short Strategy Statistical Arbitrage Market Neutral Strategy Event Driven Fixed Income Abritrage (High Yield or

Mortgage Backed) Managed Futures Emerging Markets Sector Funds Relative Value Arbitrage

Strategy Assets ($bln) Percent Assets Number Funds

Long/Short Equity Hedge

282 35% 1148

Event Driven 38.6 18% 316

Other 40.7 9% 316

Fixed Income Arbitrage

38.6 166

Global Macro 32.6 8% 146

Emerging Markets 31.7 7% 168

Market Neutral 26.8 6% 212

Convertible Arbitrage

22.2 5% 124

Dedicated Short 1.2 -- 17

Source: Lipper/Tass

Very difficult to gauge for certain Voluntary disclosure Survivorship bias Backfill bias

Must be Risk-Adjusted Normal risk adjustments don’t always apply Often a strong systemic (sector) risk

January 1995 – April 2006 Study Pre-fee annualized return of 12.72% Fee of 3.74% Alpha of 3.04% Excess returns shared roughly equally

between hedge fund managers and their investors

Convertible

Arbitrage

Distressed

Securities

Emerging

Markets

Equity Hedge

Equity Market Neutra

l

Event-Driven

Fixed Incom

e Arbitra

ge

Fixed Incom

e Convt

Bonds

Fund of

Funds

Macro Merger Arbitra

ge

Market Ti

Relative

Value Arbitra

ge

Dec 1993 15.22 32.54 87.10 27.94 11.11 28.22 16.64 23.60 26.32 53.31 20.24 24.18 27.10

Dec 1994 -3.73 3.84 7.65 2.61 2.65 6.00 11.94 -0.62 -3.48 -4.30 8.88 3.49 4.00

Dec 1995 19.85 19.73 9.02 31.04 16.33 25.11 6.08 19.17 11.10 29.32 17.86 12.58 15.66

Dec 1996 14.56 20.77 35.69 21.75 14.20 24.84 11.89 18.24 14.39 9.32 16.61 13.47 14.49

Dec 1997 12.72 15.40 19.85 23.41 13.62 21.23 7.02 17.60 16.20 18.82 16.44 13.57 15.93

Dec 1998 7.77 -4.23 -36.39 15.98 8.30 1.70 -10.29 7.53 -5.11 6.19 7.23 24.82 2.81

Dec 1999 14.41 16.94 40.06 44.22 7.09 24.33 7.38 36.94 26.47 17.62 14.34 26.17 14.73

Dec 2000 14.50 2.78 -9.39 9.09 14.56 6.74 4.78 -11.17 4.07 1.97 18.04 11.79 14.43

Dec 2001 13.37 13.28 11.51 0.31 6.71 12.18 4.81 3.30 2.80 6.87 2.76 4.09 8.92

Dec 2002 9.07 5.28 -0.03 -4.71 0.98 -4.30 8.77 -13.07 1.01 7.42 -0.86 -3.26 5.42

Dec 2003 9.93 29.58 32.41 20.53 2.46 25.33 9.35 17.52 11.62 21.44 14.39 15.38 9.72

Dec 2004 0.97 18.21 16.92 7.66 4.63 14.23 5.15 8.60 6.39 4.72 3.51 3.68 5.03

Management Fee of 1% - 2% of assets under management (median is 1.5%)

Incentive Fee of 20% of profits above a benchmark May be T-bill rate May be zero

No incentive fees in mutual funds

Mutual Funds must redeem shares on demand

Mutual Funds must calculate NAV daily Hedge Funds often invest in illiquid

assets that cannot be easily priced due to infrequent trading

Models (estimates) are often used to value assets Mark-to-Model Leads to positive serial correlation in returns

Hedge Funds will not necessarily allow withdrawls on demand Usually specific times (quarterly) when

investors can withdraw funds Often a lock-up period of up to two years

Minimum Investment of $200,000 or more

Limited number of investors and dollars Diseconomies of scale Managers want long-term investors

Allows for diversification among Hedge Funds

Fund manager is responsible for due dilligence of various hedge funds

Allows for smaller investments and greater liquidity

Additional fee of approx. 1% About 15% of all hedge fund assets

managed through fund of funds About 25% of hedge funds are actually

funds of funds

“Fat Tails” – High positive returns, but also a possibility to lose everything like LTCM Extremely unlikely in mutual fund

Lack of liquidity Lack of information for investors High Leverage Difficult to evaluate performance

CS F B/T re m on t Em e rg in g M a rke ts In de x : F e b rua ry 1994 - Ju ne 2005Returns Histogram

Return

NumberCS F B/T re m on t Em e rg in g M a rke ts In de x : F e b rua ry 1994 - Ju ne 2005

Returns Histogram

-24.0% 18.0%-22.0% -20.0% -18.0% -16.0% -14.0% -12.0% -10.0% -8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

0

30

2

4

6

8

10

12

14

16

18

20

22

24

26

28

Style Correlations

  Distressed EmergingMarkets

EquityMarketneutral Even Multi Fixed Income Macro HF Index Futures FoF

Distressed Index 1 0.5823 0.363 0.9357 0.7509 0.3117 0.3161 0.5796 -0.1267 0.661

Emerging Markets Index 0.5823 1 0.2464 0.6653 0.6665 0.2751 0.419 0.6535 -0.0991 0.7399

Equity Market Neutral Index 0.363 0.2464 1 0.3918 0.3658 0.1133 0.2098 0.3364 0.1231 0.4441

Event Driven Index 0.9357 0.6653 0.3918 1 0.9317 0.3881 0.3824 0.6691 -0.1741 0.7577

Multi-Strategy Index 0.7509 0.6665 0.3658 0.9317 1 0.4289 0.4279 0.6878 -0.1948 0.7616

Fixed Income Arbitrage Index 0.3117 0.2751 0.1133 0.3881 0.4289 1 0.4541 0.4476 -0.0685 0.426

Global Macro Index 0.3161 0.419 0.2098 0.3824 0.4279 0.4541 1 0.8587 0.2445 0.6453

Hedge Fund Index 0.5796 0.6535 0.3364 0.6691 0.6878 0.4476 0.8587 1 0.1264 0.9082

Managed Futures Index -0.1267 -0.0991 0.1231 -0.1741 -0.1948 -0.0685 0.2445 0.1264 1 0.1171

Fund of Funds 0.661 0.7399 0.4441 0.7577 0.7616 0.426 0.6453 0.9082 0.1171 1

Ranked by Average Annual Return for prior 3 years

RAB Special Situations Fund 47.69% The Children’s Investment Fund 44.27% Highland CDO Opportunity Fund 43.98% BTR Global Opportunity Fund, Class D

43.42% SR Phoenicia Fund 43.10% Atticus European Fund 40.76% Gradient European Fund A 39.18%

John Paulson, Paulson & Co. $3 billion+ Philip Falcone, Harbinger Capital Partners $1.5-

$2 billion Jim Simons, Renaissance Technologies $1 billion Steven A. Cohen, SAC Capital Advisors $1 billion Ken Griffin, Citadel Investment Group $1-$1.5

billion Chris Hohn, The Children’s Investment Fund

$800-$900 million Noam Gottesman, GLG Partners $700-$800

million

You think a stock (or portfolio) is underpriced

But you also think the market might drop You want to capture the underpricing

without subjecting yourself to the risk of your position losing value along with the market

You need to separate the stock-specific bet from the effects of the market

This is called any of the following: Pure Play Alpha Transfer Portable Alpha Creating a market-neutral portfolio

The key is to eliminate the market (systematic) risk

Example: You have put together a portfolio which you

believe will outperform the market by 2% next month.

Your portfolio has a beta of 1.0 and you suspect that the overall market will fall next month

The risk-free rate is 1% per month E(R) = Rf + β(Rm – Rf) + α + e You must create a portfolio with a beta of -1.0

which will offset the suspected market drop

You can create a portfolio with a negative beta by: Selling S&P 500 futures contracts Purchasing puts on S&P 500 contracts Shorting a SPDR ETF

Each of these creates a beta of -1.0. You can adjust this beta by borrowing or

lending at Rf

You now have a total position with a beta of zero

E(R) = Rf + β(Rm – Rf) + α + e Your return will be the 1% risk-free rate,

the 2% alpha (if you were correct) and any undiversified unique risk that remains (expected value of zero)