KCS Fund Strategies Inc.Disciplined Fund of Hedge Funds Portfolio Management
Contemporary Perspectives on Hedge Fund Investing
CFA Victoria – February 21st, 2007
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Agenda
Why add hedge funds to a portfolio?
Why take a portfolio approach?
What are the merits of low volatility hedge funds?
Is an equity investing framework useful?
Page 3
What is a Hedge Fund?
Page 4
DescriptionWhat is a Hedge Fund?
Similar to mutual fund Professionally managed pool of assets Specified objectives
Investors typically must be qualified or accredited
Short positions/hedging allowed Leverage Position concentration Lower liquidity Trading strategy ≠ investment strategy
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Hedge Fund Strategies
1. Equity Long/Short2. Equity Market Neutral3. Dedicated Short Bias4. Emerging Markets5. Convertible Arbitrage6. Fixed Income Arbitrage7. Event Driven
Merger Arbitrage Distressed
8. Global Macro 9. Managed Futures / CTA10. Multi-Strategy
What is a Hedge Fund?
Page 6
Hypothetical Convergence/Divergence Pairs Trade
50
60
70
80
90
100
110
Pri
ce
Asset 1 Asset 2
Trade Completed
Trade Initiated
Trade Completed
Trade Initiated
What is a Hedge Fund?
Typical Hedge Fund Trade
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Typical Hedge Fund Trading ModelWhat is a Hedge Fund?
A convergence hypothesis underlies the trading model of most hedge fund managers
Trading models are analogous to business models for private or public companies
Evaluation of likelihood of success is similar: Focus on quality, track record of managers Ensure strategy is well articulated Look for sustainable competitive advantages
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Why add Hedge Funds to a Portfolio?
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Stability of Returns & Outperformance
Why add Hedge Funds to a Portfolio?
Growth of $100 since February 1997*
75
100
125
150
175
200
225
250
Feb-97 Feb-98 Feb-99 Feb-00 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06
Tremont Index HFR FoF Index TSX Index S&P 500 Index Scotia Bond Index
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High Return per Unit of Risk
CSFB/Tremont Indices vs. Traditional Assets – Since February 1997
9.8%
7.2%
9.0%7.1%
15.2%16.3%
0%
5%
10%
15%
20%
Tremont Hedge Fund Index S&P 500 TSX
Returns
Standard Deviation
Why add Hedge Funds to a Portfolio?
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Diversification Benefits
Correlations – Since February 1997
CSFB/Tremont S&P 500 TSX
S&P 500 0.43
TSX 0.62 0.79
Scotia Bond Index 0.12 -0.02 0.05
Why add Hedge Funds to a Portfolio?
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Drawdown & Recovery Drawdown
Period of negative returns from peak to trough
Hedge Fund Indices Less severe and faster recovery
Other Metrics - Since February 1997
% PositiveMonths
Maximum Drawdown
Months to Recover
/ % Yet to Recover
S&P 500 60.5% -46.28% 52 / 6.55%TSX 61.3% -45.05% 38 / none
Scotia Bond Index 69.7% -11.19% 9 / noneHFRI Conservative FoF Index (HFRI CFI) 77.3% -6.62% 6 / none
CSFB/Tremont Index 71.4% -13.81% 12 / none
Why add Hedge Funds to a Portfolio?
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The Need for a Portfolio Approach
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26.27%
83.18%
55.59%
16.40%
0
10
20
30
40
50
60
70
80
90
BCE Nortel Kinross TSX
Annualized Standard Deviation of Various Equities
Benefits of Portfolio ApproachNeed for a Portfolio Approach
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Benefits of Portfolio ApproachNeed for a Portfolio Approach
13.72%12.44%
7.82%5.81%
0%
5%
10%
15%
20%
25%
30%
10 Largest Canadian
Hedge Funds
Annualized Standard Deviations of Hedge Funds
10 Largest Global
Hedge Funds
CSFB/TremontHedge Fund
Index
HFRI Fund of Funds
Index
Page 16
Risk of One Stock vs One Hedge FundNeed for a Portfolio Approach
BCE - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
Representative Canadian Hedge Fund - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
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Risk of non-“Blue Chip” stocks
Some extreme returns exceed scale and are lumped at +/- 50%
Nortel Networks Corp. - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
Kinross Gold Corp - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
Need for a Portfolio Approach
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Risk of Hedge Fund Index vs Equity IndexS&P 500 Index - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
Credit Suisse / Tremont Hedge Fund Index - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
Need for a Portfolio Approach
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Risk of Hedge Fund Index vs Equity Index
Need for a Portfolio Approach
TSX Index - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
Scotia Capital Universe Bond Total Return Index - February 1997 to December 2006
0%
5%
10%
15%
20%
25%
30%
35%
40%
50%40%30%20%10%0%-10%-20%-30%-40%
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The Merits of Low Volatility Hedge Funds
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Hedge Fund Strategy Risk Profiles
Hedge Fund Strategies to the left are less volatile and have higher return per unit of risk (i.e. standard deviation).
Merits of Low Volatility Hedge Funds
CSFB/Tremont Risk/Return - Since February 1997 - Annualized
9.9% 9.8%
5.4%9.0%
10.7%11.9% 12.4%
7.1%9.6%
-1.5%
2.7% 3.6% 3.8% 4.8% 5.9%9.4% 10.7%
11.9% 15.0%
17.8%
-5%
0%
5%
10%
15%
20%
Equity MarketNeutral
Multi Strategy
Fixed IncomeArbitrage
ConvertibleArbitrage
Event Driven
Global Macro
Long / ShortEquity
ManagedFutures / CTA
EmergingMarkets
DedicatedShort Bias
TremontReturnsTremont StdDeviation
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Hedge Fund Strategy Betas
Hedge Fund Strategies to the left have lower beta (i.e. sensitivity) to the S&P 500.
CSFB/Tremont Strategy Betas vs. S&P 500 - Since February 1997
0.07 0.04 -0.01 0.040.21
0.10
0.40
-0.13
0.54
-0.91
-1.0
-0.5
0.0
0.5
1.0
Equity MarketNeutral
Multi Strategy
Fixed IncomeArbitrage
ConvertibleArbitrage
Event Driven
Global Macro
Long / ShortEquity
ManagedFutures / CTA
EmergingMarkets
DedicatedShort Bias
Merits of Low Volatility Hedge Funds
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Best Diversification includes Global HFs Globally $1.5 Trillion with 8,000 managers Canada approx. $60 Billion with 70+ managers (Canada
Hedge Watch)
As of December, 2006
Scotia HF Index
CSFB/Tremont Index
27 Managers Strategies 341 Managers
39 Funds 410 Funds 56 % Equity L/S 28 % 11 % Multi -Strategy 11 % 10 % Market Neutral 4 % 9 % Event Driven 24 % 2 % Managed Futures 5 % 2 % Fixed Income 8 % 3 % Global Macro 11 % 0 % Emerging Markets 4 % 2 % Convertible Arbitrage 2 % 2 % Dedicated Short Bias 1 %
3 % Other 2 %
Need for a Portfolio Approach
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Applying an
‘Equity Investing Framework’
to Hedge Funds
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U.S. Value Stock Selection ProcessQuantitative Screens Price-to-book Price-to-earnings Dividend-Yield Create ‘Short list’
‘Short list’
10,000+ US equities
Diversified Mutual Fund
Quantitative Screens
Bottom Up Analysis
Qualitative Analysis Bottom-up company review Core competencies and competitive
advantages Industry position
Diversified Portfolio Reduces risk Manager monitors holdings
Applying an ‘Equity Investing Framework’
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Hedge Fund Selection ProcessQuantitative Screens Understand drivers of returns Assessment of risks Consistency of results with stated strategy Quantitative fit with overall portfolio
‘Short list’
8,000+ US and International hedge funds
Diversified Portfolio of Hedge Funds
Quantitative Screens
Bottom Up Analysis
Qualitative Assessment Bottom-up manager review Core competencies and competitive
advantages Qualitative fit with overall portfolio Nature and extent of risk controlsDiversified Portfolio Reduces risk Manager monitors holdings
Applying an ‘Equity Investing Framework’
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Demands of Hedge Fund Investing Successful hedge fund investing requires:
Expertise in analyzing trading strategies as businesses Entry and exit discipline Time commitment Sufficient size of investment to allow diversification
Need more than a single manager multi-strategy
Decide between: Self manage Outsource
Custom portfolio Funds of hedge funds
Combination
Applying an ‘Equity Investing Framework’
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KCS Approach
Page 29
Investment Strategy Based on
10 years Hedge Fund Investing experience AIMA Award-winning Research Proprietary Analytics Focus on risk reduction
Objectives Low volatility Low correlations with traditional assets Tax-preferred deferred capital gains ‘Equity-like’ returns with ‘bond-like’ volatility
Strategy Levered low-volatility
KCS Approach
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HF Strategy Risk Profiles & the ACRF
Notes: Weights are as at December 30, 2006. All risk/return measures are since February, 1997, and have been annualized.
CSFB/Tremont Weights vs. Current ACR Basket Weights
5.1% 9.9% 6.2%2.7%
23.1%
10.9%
29.6%
5.1% 7.0%0.5%
11.3%
40.8%
11.2% 11.9%6.3% 9.7%
2.5% 0.0% 0.0% 0.0%0%
10%
20%
30%
40%
50%
Equity Market Multi Strategy
Fixed IncomeArbitrage
ConvertibleArbitrage
Event Driven
Global Macro
Long / ShortEquity
ManagedFutures / CTA
EmergingMarkets
DedicatedShort Bias
TremontWeightsACR BasketWeights
CSFB/Tremont Risk vs. Current ACR Basket Risk - Annualized
2.7% 3.6% 3.8% 4.8% 5.9%
9.4%10.7%
11.9%15.0%
17.8%
2.3%2.8%
4.4%2.1%
6.0% 3.4% 5.9%
0.0% 0.0% 0.0%0%
5%
10%
15%
20%
Equity MarketNeutral
MultiStrategy
Fixed IncomeArbitrage
ConvertibleArbitrage
Event Driven
Global Macro
Long / ShortEquity
ManagedFutures / CTA
EmergingMarkets
DedicatedShort Bias
Tremont Std. Dev’nACR BasketStd Dev’n
KCS Approach
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Performance
+ 15.7% for 2006
Ranked #1 Fund of Funds in 2006 on
Canadian Hedge Watch
Page 32
KCS ACR Fund Performance
Fund Name for December Q1 Q2 Q3 1 Month 3 Months 6 Months YTDKCS Absolute Core Return Fund 10.56 0.067 -1.75 1.34 6.04 4.24 15.7Man Multi-Strategy (Canada) Fund Class F U$ 0.54 2.63 -6.22 12.67Arrow Focus Fund Class F2 11.92 -3.68 -2.02 2.24 6.28 4.13 12.25Arrow Global Long/Short Fund Class F 9.71 -3.69 -1.38 2.33 7.3 5.82 11.81Arrow Multi-Strategy Fund Class G U$ Class F 8.39 -0.69 -1.93 2.23 5.53 3.49 11.4Mac Alternative Strategies Class O 3.84 -0.19 2.23 2.26 5.02 7.36 11.27TA3 - Mesirow 'O' US$ 2.77 1.67 0.69 1.7 3.9 4.61 9.31Tremont Core Diversified Fund U$ Class O 3.44 0.54 1.12 1.45 3.86 5.03 9.23Pro-Hedge Elite Fund Class F 8.96 -4.9 -3.25 1.32 4.8 3.94 7.7TA3 - Safeguard US$ 2.14 1.03 0.04 1.48 3.24 3.28 6.57Pro-Hedge Capital Preservation Fund Class F 3.05 0.27 0.48 0.29 1.29 1.77 6.41Arrow Enhanced Income Fund Class F 2.09 1.71 -0.9 1.12 2.45 1.95 5.86Pro-Hedge Capital Preservation PLUS Class F 4.12 -1.03 -0.78 0.1 1 0.22 5.33TA3 - Hybrid 'F' C$ 2.21 -1.65 -1.58 3.42 5.74 4.08 4.62Quadrexx Market Neutral Performance Fund Series F 7.44 -0.67 -2.75 0.49 0.47 -2.3 4.27Pro-Hedge Capital Preservation USD Class A 2.69 -0.08 0.16 0.2 0.99 1.16 4.18Horizons Diversified Fund 2.96 -1.3 -1.97 3.36 3.92 1.87 3.51Tremont Capital Opportunity Trust 3.22 -1.38 -3.2 0.37 -1.09 -5.83 1.49Abria Diversified Arbitrage Trust Class O $US 3.26 3.36 0.67 0.86 -6.02 -5.39 0.98Pescara Fund of Funds U$ 2.09 1.03 -7.06 -9.1 -12.56 -18.74 -16.19Abria XL Trust Class O U$ 0.00 -19.89HRS Absolute Return Trust 4.52 -0.42 0.42 3.06 3.67 1.92 8.19Stanton Diversified Strat LP - Class A C$ 151 0.00 1.82 -6.11
* For Internal Use Only - from www.canadianhedgewatch.com
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Questions and comments?
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This presentation is confidential. The contents are not to be reproduced or distributed to the public or the press. Securities legislation may prohibit such distribution. This presentation is a summary only and should be used in conjunction with the detailed information in the Confidential Offering Memorandum. The information contained in this presentation is believed to be reliable, but is not guaranteed as to its accuracy or completeness. This presentation is for information purposes only and does not constitute an offer to sell or a solicitation to buy the securities referred to herein. No securities commission or similar regulatory authority has reviewed this document or has in any way passed on the merits of the securities describe and any representation to the contrary is an offence.
Historical performance is not a guarantee future results. KCS Fund Strategies Inc. recommends consulting appropriate investment and financial advisors when considering any investment decision.
KCS Fund Strategies Inc.
2150 – 555 West Hastings Street
Vancouver, British Columbia
V6B 4N6
Ph: 604-730-0729 x 225www.kcsfunds.com