Alternative Asset Management Group

Alternative Investments: Hedge Fund Industry Review 2004

and Perspectives 2005

Union Bancaire Privée • 96-98, rue du Rhône • 1211 Geneva 1 • Tel. +4122 819 2111

2

Continued Friendly Growth for Financial Markets

• The world growth will reach 3% in 2005; the US, China and some emerging lead the growth.

• The US and Chinese demands fuel the supply from the rest of the world. The industrial cycle remains in a good shape, but the demand varies across the regions.

• Capex and exports should remain the most dynamic components of GDP.

• Inflation is under control; oil prices remain a source of volatility.

• Private demand and supply are keys in this phase of the cycle; the end of reflation policy, except perhaps for Japan.

• Policy-mix manages a gradual return to neutral monetary rates and more balanced budgets.

• Ingredients to the 2005 profit cycle: a mixed of still robust volumes rising margins and some restructuring.

3

World Scenario: Moderate and Less Synchronized Growth

GDP YoY%, vol.

World USA Asia Japan Euroland Switzerland

2003 2.8 3.1 6.4 1.5 0.4 -0.5

2004 3.9 4.4 7.2 2.6 1.7 1.7

2005 2.9 3.3 6.0 1.0 1.4 1.4

4

Emerging Countries: High Growth to be Managed

• Growth in emerging countries remain on a high level; structural high growth in demand.

• The high growth trend could generate frictions: stop and go policies, inflation pressures, mixed results in policy-mix.

• 40% of the world population will be located in India-Asia area in 2050.

5

Eurozone: Weak and Uncertain Growth

• The industrial cycle shows some revival thanks to Germany, but on a low basis; The export trend is fueled by US and Asian demand for capital goods.

• Signs of weakness are still there: a fragile growth in industry through the countries and a mixed picture in services.

• Demand side is still too fragile: unemployment is a concern and structural reforms are made at a low speed.

6

Japan: Finally Some Positive Signs

• A bottom could have been reached in production after the Q4 slowdown.

• Machinery orders are still booming, thanks to foreign orders; capex and export will continue to lead the growth.

• Service industry is in a positive trend: a booming activity in the business service sector.

• Restructuring in the economy is going on.

7

Balanced Portfolios: Continued Investments in Bonds and Risky Assets

Balanced Portfolio Asset Allocation Neutral USD Profile Euro Profile % of Total Portfolio

Cash 10 5 5

Bonds 45 40 40

Equities 25 25 25

Alternatives 20 30 30

Total 100 100 100

8

Investment Themes

• Japanese stock market

• Emerging and Asian equities

• Gold

• Commodities – natural resources

• Special situation in some emerging currencies

9

Risks in the Scenario (Again ?)On the negative side :

• Oil price shock (again?)• Geopolitics and terrorism (again?)• A new war• Systemic risks in the financial sector or specific credit

segments.• World housing markets : a post bubble correction with

negative impact on stocks• Recession in OECD• A new crisis in Asia

On the positive side:• A counter-shock in oil market• More fiscal or monetary stimulus• A growth scenario in line with potential in the G7• A G7 global agreement on currencies• End of terrorism and stabilization in the Middle East.

10

Record Asset Inflows in 2004• The hedge fund industry gained US $16.3 billion in net assets

during Q4 of 2004 year, the smallest quarterly inflow for the year• Total net flows for the industry in 2004 were a record $123 billion

compared to $72.2 billion for 2003.• Total hedge fund universe now estimated at $975 bn, with an

additional $300 bn in privately managed accounts.• UBP independently estimated to be third largest allocator, with

AuM of around $18.1bn• Strategies attracting greatest share of net assets in 2004:

Long/Short Equity, at £33 bn, Event Driven at 25.7 bn, and Global Macro with $16.7 bn.

• Convertible Arbitrage and Equity Market Neutral strategies saw net outflows during Q4, largely due to the low volatility environment

• In Equity Market Neutral trading, managers with a fundamental bias performed better than those with a statistical bent.

Source: TASS

11

Hedge Fund Industry Asset Flows

All Funds January 1994 - December 2004

12

Hedge Fund Strategy Returns2004

-10

-5

0

5

10

15

13

Hedge Fund Strategy Returns Inception 1993 – December 2004

0

50

100

150

200

250

300

350

400

450

Global

Mac

ro

Long

/Shor

t Equ

ity

Event D

riven

Equity

Mar

ket N

eutra

l

Convertib

le Arb

itrage

Manage

d Fut

ures

Emergin

g Mar

kets

Fixed I

ncom

e Arb

itrage

Dedicated

Sho

rt Bias

Multi-S

trategy

CSFB/Tre

mont H

edge F

und In

dex

14

Hedge Fund Industry Assets by Strategy1993 - 2004

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

ASSETS BY STRATEGY

Global Macro & CTA

Long/Short Equity

Arbitrage / RV

15

Major Asset Classes Performances

-46.00% -36.00% -26.00% -16.00% -6.00% 4.00% 14.00% 24.00% 34.00% 44.00%

CSFB/Tremont Hedge Fund Index

Goldman Sachs US Commodity TR

MSCI Europe (in Local Currency)Index

Gold Price

Euro/USD

Nikkei 225 Index

S&P 500 Price Index

MSCI World Price Index

NASDAQ Composite Index

MSCI Emerging Market Free

200420032002

16

VIX Volatility Index

• Of 126 months where the VIX > than 20% 168 bps out-performance of HRF FoF US where VIX < 20%.

• Mid-level volatility (VIX at 18-25%) is best for hedge funds• Volatility spikes negative hedge fund returns and low volatility

sub-level returns.

17

Hedge Fund Performance 2004• Are Hedge-Funds suffering only from increased assets allocated?• Reversal of trends (FX, rates, metals), concomitant decline in equities and

bonds, historically low volatility• Poor environment for hedge funds when:

Both stocks and bonds decline (1994, 1998, Q2/3 2004) Fed liquidity tightens Commodity AND currency markets range-bound or choppy (2004

except oil) Low Equity market volatility Little opportunity for hedge funds

• Few investors have been invested in hedge funds long enough to have experienced low hedge fund performance. Periods of negative performance are “normal” events. Happens every 2-3 years: 1994, 1998, 2001, and 2002 all had performances at or below 2004 levels.

• Q2/Q3 ’04 didn’t look so difficult for outsiders attribution to AuM inflows.

• Volatility and volumes resumed after US elections performance too.

18

FoF Performance vs Market Behavior 2004

Data Points S&P 400 SSB US Govt Bond Index 10+ year, local currency terms

HFRI Fund of Funds Composite Index

126 Months Month Ended Month Ended Months Profitable

19 Down Down 37%

47 Down Unchanged 38%

28 Down Up 39%

49 Unchanged Up 61%

30 Up Down 77%

49 Up Up 86%

Source: Source Weston Capital Management

19

Long-Short Global

• 2005 commenced quite strongly: performances generated in Asia and EU• 2004 performances fairly good; managers on our Approved List returning an

average 7.5% (end October) • Most of performances generated in US some in UK• Trend towards fundamental analysis & deep value approach reinforced• Managers favoring concentrated positions • Lessened impact of Macro Overlay; led to decoupling of returns vs intrinsic value

of positions• Growing discrepancies between the performances of the EU / Asia and US markets.

2004 -To-Date

Outlook 2005

• Markets increasingly attractive on fundamental/value perspective, particularly in Asia and Europe

• Managers with real Asia/Japan experience expected to do well • Monitor market reaction to lower USD

20

Long-Short Equity US

• Good results vs opportunities offered by equity markets. Most of the managers survived the drop in January 05 , and made strong recoveries in February.

• Fundamental/deep value approach will continue to outperform.

• Concentration in portfolios

• Diversified portfolios have underperformed, tracking range-bound market movements

• Corporate events or special situations performed well; has attracted lot of assets and arbitrage opportunities are being closed fast, leaving little time to perform detailed fundamental research.

2004-To-Date

Outlook 2005

• Fundamental approach will prime

21

Long-Short Equity Europe

• European sector L/S Equity strategies’ average 04 returns were 5.96%

• As for US, European sector benefited from value plays vs growth stories. Strong cash flows and annuities, visibility of recurring revenues, performed well & present in many funds

• Concentration, Themes (e.g. energy) and Sector focus outperformed

• Valuations cheaper than US; more liquid and less volatile markets.

• Knowledge edge and fundamental research outperformed

2004-To-Date

Outlook 2005

• Careful with macro events; ie USD weakness

• Will focus on managers with strong analytical capabilities and concentrated portfolios

22

Long/Short Japan

• In the 1st quarter, Japan was foreign investors’ market favourite, on the back of increased signs of an economic recovery and easing deflation.

• Since May, Japanese markets have corrected around 14% from peak to trough: this was a necessary adjustment to market frenzy of Q1.

• Most Japanese L/S managers were able to capture the Q1 rally. The most profitable themes were “reflation” and consumption-related themes.

• Despite being hard-hit by the market correction, the average performance of our L/S Japanese managers was good, with average returns of 9%. Best performers were opportunistic managers, as they were able to quickly adjust their exposure according to their top-down view.

• Micro picture is still positive: record cash flow after years of corporate restructuring, management likely to be more friendly toward shareholders to guard against hostile takeovers.

• Macro: BOJ forecasts nationwide CPI to grow 0.1% in fiscal year 05, signaling an end to deflation.

• Major risks: Crude oil price, as Japan is a net importer (each $10 move in crude oil is said to shave off 40bps off of Japanese GDP), strength of Yen which affects Japanese export companies

• Will slowing export growth be offset by renewed domestic consumption?

2004

Outlook 2005

A Cyclical Rally or the Beginning of Sustained Recovery ?

23

Long/Short Asia

• Asian managers had a disappointing year compared to 2003, with an average performance of 9% compared to MSCI AP x Japan returning 19%.

• Most managers have been hit hard by market collapse in April and May, with China shares losing 30% from their high in Jan’04.

• The sell off was substantially wider and affected all Asia Pacific markets• Yet, corporate fundamentals were still strong : strong corporate earnings

forecasts, solid cash flow• Therefore, the disconnect between good fundamentals and negative market

sentiment hurt Asian L/S managers, given that: They tend to have a net long bias and are therefore affected by market correction Cheap valuations did not justify raising short exposure

• Significant risks: US & global slowdown, crude oil price, will foreign investors continue to allocate capital to the region ?

• China’s buoyant economic growth does not necessarily translate into stock market gains : wave of corporate scandals (China Aviation Oil), reminding investors that corporate governance still not top of priority

• Over the long term, structural outlook for the region however remain impressive: strong demographics, Asia’s share of global GDP growth now represent 27%

2004

Outlook 2005

A Turbulent Year

Short term cautious, long term bullish

24

Technology

• Long-term outlook for the TMT sector is very positive, based on supposition that PC and Internet migration to wireless will drive the sector.

• We believe wireless communications will produce a watershed convergence of voice video and data that will alter the technology landscape.

• However, in the medium-term the sector remains volatile.

2004-To-Date

Outlook 2005

• The Nasdaq drifted during much of 2004, rallied in Q4 on a series of strong earnings reports;

• Investors welcomed the Bush victory• TCS, inherently long-biased, performed extremely well thanks to great stock-

picking on both the long and the short sides• Level was the best-performing trading-oriented fund. Seeing no clear trends in the

technology sector, they continue to be nimble and operate with low net exposure and high turnover.

• Most opportunistic-driven managers were able to profit from the environment. Cantillon made money on short semi-conductor positions.

Mixed Results

25

Healthcare

• Healthcare industry severely hit due specific events; e.g. Chiron's failure to provide flu vaccines and Merck's Vioxx withdrawal highlighted concerns about vulnerability to lawsuits and increased regulatory scrutiny of drug safety.

2004-To-Date

Outlook 2005

• Even though the long-term outlook remains positive, given the needs of an aging population, the currently low valuation and continued innovation, 2005 presents a very difficult trading environment as regulatory issues persist.

• Recommend: caution.

26

Natural Resources

• China‘s demand for raw material is high• World’s most populous country expands at annual rate of more than 9%• China is building 25 new nuclear plants: the price of Uranium will probably rise• Oil: Geopolitical risk: Insurgent attacks on Iraqi pipelines• Under investments in infrastructure and exploration over 10 years• Recommendation: favor long biased funds and managers active in exploration

projects

2004-To-Date

Outlook 2005

• Very strong performances from energy-related funds as oil prices rose sharply • Strong performance from Natural Resources funds (RAB, Wessex) as markets

remain favourable for the strategy.

The Bull Case for Natural Resources

27

Fixed Income

• Historically low Credit spreads; tightening more pronounced for high yield than investment grade spreads

• Tight spreads sustained by: A low credit default environment Strong credit fundamentals Strong demand for yield

• Yield curve arbitrage had difficult year due lack of clear trends

• Spreads to remain tight and range-bound near term, widening medium/long term • Catalysts may be earnings, lower demand as credit becomes expensive, oil price

hikes and geopolitical risks. Companies beginning to use their liquidity: increased M&A

• Formation of yield curves trends have started; Flattening of the curve has been an early theme (US & Europe)

• 2005 will be challenging for pure credit funds. Any Volatility pick-up and spread widening would mean careful selection of funds

• Recommendation: Funds diversified across fixed income strategies and able to implement effective shorts in a credit pullback scenario

2004-To-Date

Outlook 2005

28

Merger Arbitrage/Event-Driven

• Increase in announced deals • The spreads are unappealing as closely correlated to interest rates, plus

market over-arbitraged• In the US, the average IRR per deal is around 4-5% which is 3 to 4 times

below 1999 and 2000 levels• The risk of a deal break and related cost is too high for reward• Spreads in Europe slightly higher since less capital allocated to strategy,

rates slightly higher and barriers of entries for arbitrageurs higher due complex and regulatory environment; Favors strong experience

• Prudent and not optimistic on Risk/Reward• Increasing pace of announced deals expected – spreads not expected to

widen

Outlook 2005

2004-To-Date Disappointing returns

29

Convertible Arbitrage

• Performances ranging from -2% to +2%• Performances in line with market environment and strategies implemented by managers• Constant evolution of strategy and portfolios; today far more sophisticated vs 2000-2001 • Volatility bias strongly penalized as realized volatility continues to drift lower than

implied volatility• Credit exposure or special situations posted performances above averages (e.g.

Alexandra)• Continuing shift from managers toward a volatility-biased portfolio based on volatility

cheapness and credit spreads at historically tight levels• Little issuance and small issue size• Drift toward multi-strategy structure with event-driven and capital structure

arbitrage(e.g. Alexandra, K-Street)

• Focus on managers with original approach to convertible market, and those able to transform infrastructure into multi-strategy platform with adequate resources

• Convertible funds with strong bias to volatility are cheap market hedge to equity markets due historical low level of volatility

• Favour those managers with a strong fundamental bias.

2004-To-Date

Outlook 2005

30

Distressed Credit and High Yield

• Strong year for credit as distressed and high yield managers average +10% - 15% for the year as of November

• Main driver is Institutional Investor behavior, not improvement in economic and business fundamentals

• Credit-picking is key component today• Spreads tightening and yields declining with higher implied risk (credit deterioration) • Could be sign of credit cycle reaching its peak; lending standards widen and low

ratings have tight spreads• Are Investors paid for the risk?• Credit cycles reach peak when optimistic projections of business fundamentals

reach unrealistic level that can’t be ignored, the derivative leverage suddenly becomes toxic

• Seeking managers with cautious approach in current environment; Best opportunities on long side after credit deterioration

• Seeking niche player not involved in main-stream investments subject to swings of inflows and outflows of mutual funds

2004-To-Date

Outlook 2005

31

CTAs and Macro in 2004

• Both strategies profit from directional moves on Fixed Income, Currency, Equity & Commodity markets

• Macro managers seek fundamental factors for strong argument of directional move• CTAs believe once trend has started it is likely to persist• Macro: small positive returns; have kept exposure very low due lack of opportunities• CTAs: lost on strong reversals in Fixed Income, Metals and Softs markets in April; to

be seen as profit give backs after successful 2003 (trend reversals)• CTAs suffered following April from “false” breaks - primarily in currencies• Energy markets profitable for CTAs (trend)• Discretionary Macro traders performed well in Fixed Income markets• Short term strategies generally performed well, but is a very small subset• Q4 was very profitable for both Macro and CTA’s, as the weakening dollar move was

persistent and agreed on in terms of fundamentals

MOST IMPORTANTLY

• 2004 has seen most markets apart from Energy stay range bound. Currencies and equities exhibited strong moves in Q4. These traders need directional, not sideways markets

2004-To-Date

32

CTAs and MACRO Outlook

• Following factors could cause repricings in Fixed Income, Currency, Equity and Commodity markets:

Higher oil Prices Growth in US trade deficit Continued high level of Chinese Growth Pick up in US Growth Geopolitical Instability

• Markets rarely stay in tight trading ranges over a long period of time, economic and political changes occur that force rebalances

• Directional strategies have least risk that inefficiency they profit from is eroded by too many participants Markets move irrespective of CTAs and Macros due to much stronger economic forces

CONCLUSION

• Directional Markets will return and these managers will once again profit

Outlook 2004

33

Asset Allocation Strategy

Strategy CSFB Tremont Non Estimated Industry Recommended Strategy CSFB Tremont Non Estimated Industry Recommended

InvestableWeight Weights Allocation Tilt InvestableWeight Weights Allocation Tilt

Long Short Equity 26.1% + Eq. Market Neutral 4.5% 0

Regions 90.0% 0

Global 5% Fixed Income Arb 8.2% 0

US 50% ++ Directional 45%

Europe 20% + Non-Directional 50%

Asia 10% + Credit Arbitrage 5%

Japan 15% 0 Event Driven 21.6% - 0

Sectors 10.0% Event Driven Distressed -

Bio & Health 20% + Event Driven Multi Strategy +

Natural Ressources 25% + Even Driven Risk Arbitrage +

Financials 10% - Managed Futures 5.7% - 0

Gold 10% 0 Short Term 10% -

TMT 35% + Long Term 90% +

Emerging Markets 3.8% + Global Macro 12.0% - 0

Equity 40% + Fixed Income 0

Debt 60% - Diversified +

Convertible Arb. 5.0% 0

Volatility 45% +

Credit 10% -

Multi Strategy 45% 0

34

Thoughts and Trends on the HF Industry

• From marginal and specialised industry to a professional, mature industry• Focus has moved from “Quest for” absolute performance only to professionally

structured organisations and lower volatility – institutionalisation with performance as cost (however risk/reward remains good)

• More focus on volatility than performance (Buffet: “I prefer a lumpy 15% over a smooth 12%)

• Expanded universe of strategies• Absolute performance towards relative performance and capital preservation• Consolidation: small structures struggle to survive• Regulation is creeping in: Distraction from Trading will cost time and money

Not negative per se: Independent eye Challenge to avoid conflicting regulations Careful with complacency (20% of frauds were registered funds) Structural risk

• Conclusion: Distinction between Alternative Investments and Traditional Investments is disappearing. Hedge Funds – Active Management and Passive Management

Evolution

35

Thoughts and Trends on the HF Industry

• Post 1998 awareness limits excessive leverage at the hedge fund level• Lack of opportunities also limit leverage• Transfer of leverage to FoF level

“Squeeze” more performance out of managers Low cost of money

• Leverage poses a threat at FoF level due to illiquidity• Mitigated through strong portfolio diversification• Additional leverage through structured products and enhanced liquidity

through credit lines

Leverage

36

Thoughts and Trends on the HF Industry

• Access and capacity become major issues for FoF’s

• HF demand and high margins - new entrants often of lesser quality (low barriers to entry)

• New talent is not created at such speed and industry accommodates itself with lesser talent

• Need for strong research and due diligence to avoid pitfalls and remain with the best

• Bubble? Hedge Funds are a strategy, not an asset Symptoms of Bubble: Investors pay the same or more for less returns and

ignore the risk Complacency

• Mainstream Mutual Funds are adopting some money management techniques (Risk and Exposure Management) as Hedge Funds, but … at a much lower cost.

Supply/Demand Imbalance

37

Thoughts and Trends on the HF Industry

• Reasons for failure per EDHEC study 30% Fraud 41% Misrepresentation 14% Trading outside mandate 6% Poor Process

• Structural risk analysis seek to reduce exposure to such risk through review of:

Pricing policies Independence of NAV calculation Segregation of duties Infrastructure, controls and procedures Staff qualifications and experience

Increased Need for Structural Risk

38

Final Quotes

“No, this is not the end. Not even the beginning of the end. But it is, perhaps, the end of the beginning …”

Churchill

Which all results in a saner and tamer Hedge Fund World … but with a few rebellious elements

J. Frogg

“You can’t get absolute returns without taking risk …”William von Muffling