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1
The Benefits of Hedge Funds
The First Seoul International Derivatives Securities Conference
Thomas Schneeweis & Vassilis Karavas
August 28, 2003
CISDM/UMASS-Amherst 2
Outline
I. Introduction to Traditional and Alternative
Investments
II. Benefits of Hedge Fund Investment
III. Hedge Funds in Asset Allocation
CISDM/UMASS-Amherst 3
I. Introduction to Traditional and Alternative Investments
What Are Hedge Funds?
Hedge Fund Facts
Academic Evidence on Traditional Investment Performance
Academic Evidence on Hedge Fund Performance
CISDM/UMASS-Amherst 4
Introduction to Traditional & Alternative Investments
Investment Alternatives
Traditional Alternatives Modern Alternatives Traditional Investments
Private EquityCommoditiesReal Estate
Hedge FundsManaged Futures
StocksBonds
CISDM/UMASS-Amherst 5
What is a Hedge Fund?
Term “Hedge Fund” is a misnomer with little descriptive power
1950’s: A.W. Jones Model-Long/Short U.S. equities-Capture two opportunity sets while reducing overall market exposure-“Hedge Fund” term accurately reflected the underlying strategy
2000’s: Generic reference to a private, commingled vehicle investing in marketable securities
-Strategy characteristics vary widely-Markets in which they participate vary widely-Risk/return characteristics vary widely-Common organizational and structural characteristics
CISDM/UMASS-Amherst 6
What are Hedge Funds?
Various Definitions
A multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction.
A loosely regulated private pooled investment vehicle that can invest in both cash and derivative markets on a leveraged basis for the benefits of its investors.
A hedge fund is a private investment portfolio, usually structured as a limited partnership, open to accredited investors, charging an incentive based fee, and managed by a general partner with every financial tool imaginable at his disposal.
CISDM/UMASS-Amherst 7
Hedge Fund Classifications
Relative Value Market Neutral Equity (Long undervalued/short overvalued stock) Convertible Hedging (Long convertible. bonds/short stock) Bond hedging (Yield curve arbitrage)
Event Driven Corporate transactions and special situations Deal Arbitrage (Long/short equity involved in corporate transactions) Bankruptcy/Distressed (Long securities involved in financial distress) Multi-strategy (Deal arbitrage and bankruptcy)
Equity Hedge Funds Domestic Long (Long undervalued US equities) Domestic Opportunity (Long/Short Equity (long bias))
Global Asset Allocators/Global Macro Systematic (trend-following or other quantitative analysis) Discretionary (Long or short markets based on fundamental analysis)
Short Sellers
CISDM/UMASS-Amherst 8
Hedge Fund Facts
Hedge funds are not riskier than traditional stock and bond investments
Not all hedge funds are highly levered
Most hedge funds trade in liquid and transparent markets
Hedge fund strategies have existed for decades
Hedge funds are not absolute return investments (e.g., make money in all markets) but do offer unique risk and return opportunities not available in traditional stock and bond markets.
CISDM/UMASS-Amherst 9
Academic Evidence on Traditional Asset Investment Performance
Actively managed stocks and bond portfolios provide little alpha (excess return relative to benchmarks)
With increased globalization, stock and bond investment provide limited diversification
CISDM/UMASS-Amherst 10
Little Evidence of Equity Fund Alpha (1996-2002)
Return Comparison of Lipper and S&P Indices
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
Lipper
LipperLipper
LipperLipper
Lipper
S&P S&P
S&P
S&P
S&PS&P
CISDM/UMASS-Amherst 11
Little Evidence of Diversification Benefits Across Stock Markets (1990-2002)
Ranked Equity Returns on S&P 500 (1990-2002)
-10.00%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
1 2 3 4 5 6 7 8 9 10 11 12
Ranked ReturnsAve
rage
Mon
thly
Ret
urn
s
S&P 500 T otal Return MSCI World
MSCI N. Amer. MSCI Europe
MSCI Pacific MSCI Far East
CISDM/UMASS-Amherst 12
Academic Evidence on Hedge Funds
Hedge funds and CTAs offer the potential for alpha (excess return relative to common benchmarks such as equal risk S&P 500 or Lehman Bond Indices)
Hedge funds and CTAs offer the potential for diversification to existing stock or bond portfolios
Multi-factor models which describe return process for stocks and bonds also describe the return process for hedge funds
Modern methods of asset allocation used to deliver desired risk and return tradeoff for stocks or bonds can also be used for hedge funds
CISDM/UMASS-Amherst 13
Evidence of Hedge Funds in Providing Diversification Benefits Relative to Stocks and Bonds (1990-2002)
Divers ification Bene fits Ranked on Lehman US Aggregate 1990-2002
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
1 2 3 4 5 6 7 8 9 10 11 12
Ranked Portfolios
Ave
rage
Mon
thly
Ret
urn
s
S&P 500 Total Return Index Lehman U.S. AggregateLehman Global Aggregate EACM 100
CISDM/UMASS-Amherst 14
II. Benefits of Hedge Funds
Why Hedge Funds?
Source of Hedge Fund Benefits
Analysis of Hedge Fund Returns
CISDM/UMASS-Amherst 15
Hedge funds represent a large and growing industry that offers investors an opportunity to diversify and to earn competitive returns with low to moderate volatility.
Annualized Return and Standard Deviation (1996-2002)
CISDM $ Weighted CTA Index
Lehman US AggregateS&P 500
EACM 100
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Annual Return Standard Deviation
Correlation of EACM 100 With Other Indices (1996-2002)
CISDM $ Weighted CTA Index
Lehman US Aggregate
S&P 500
0.00
0.10
0.20
0.30
0.40
0.50
0.60
Why Hedge Funds?
CISDM/UMASS-Amherst 16
Source of Hedge Fund Benefits
Unique Return Opportunities Strategy based Manager based
Unique Diversification Opportunities (use wider range of instruments
Different sources of return (long and short investing, concentrated asset positions)
CISDM/UMASS-Amherst 17
Hedge Fund Performance Indices
Active manager based peer indices (similar to Morningstar or Lipper Mutual Fund Indices)
EACMCSFB/TremontHFRCISDMMSCIS&PZurich
Note: Academic research has shown that use of different indices may show different levels of risk and return benefits but basic conclusions are the same regardless of performance index used.
CISDM/UMASS-Amherst 18
PerformanceEACM 100 S&P 500 Lehman Gov./Corp. MSCI Lehman
January 1990-December 2002 Bond Global Bond
Annualized Return 12.83% 9.68% 8.30% 4.20% 7.65%Annualized Standard Deviation 4.28% 15.28% 4.25% 15.08% 5.03%Sharpe Ratio 1.88 0.32 0.83 -0.04 0.57Minimum Monthly Return -4.45% -14.46% -2.45% -13.35% -2.97%Correlation With EACM 100 0.41 0.15 0.41 0.04
Portfolio I Portfolio II Portfolio III Portfolio IVS&P 500 & S&P 500, Lehman Bond MSCI and MSCI, Lehman Global Bond
Lehman Bond and EACM 100 Lehman Global Bond and EACM 100
Annualized Return 9.30% 10.05% 6.21% 7.55%Annualized Standard Deviation 8.25% 7.00% 8.43% 7.11%Sharpe Ratio 0.55 0.75 0.17 0.39Minimum Monthly Return -6.25% -5.89% -5.63% -5.39%Correlation with EACM 100 0.42 0.37
Portfolio I = 50% S&P 500 and 50% Lehman Brothers Gov./Corp. BondPortfolio II = 40% S&P 500, 40% Lehman Brothers Gov./Corp. Bond and 20% EACM 100Portfolio III = 50% MSCI and 50% Lehman Brothers Global BondPortfolio IV = 40% MSCI, 40% Lehman Brothers Global Bond and 20% EACM 100EACM 100 = Index of Hedge Fund Strategies
Hedge Funds: Return/Risk Performance
CISDM/UMASS-Amherst 19
Return and Risk Tradeoff: 1990-2002
EACM Sytematic (CTA)
Lehman U.S. Aggregate Bond
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Annualized Standard Deviation
An
nu
ali
zed
Retu
rn
EACM 100
EACM Event Driven
EACM Equity Hedge
S&P 500
EACM Relative Value
Hedge Funds Provide Higher Return Compared to Traditional Assets
CISDM/UMASS-Amherst 20
Risk and Return of Stock, Bond and Hedge Funds: January 1990-December 2002
100% EACM 100
100% S&P 500
100% Lehman Bond
50% S&P 500 and 50% Lehman Bond
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%
Portfolio Annualized Standard Deviation
Po
rtfo
lio
An
nu
aliz
ed R
etu
rn
Hedge Funds Provide Enhanced Return/Risk Performance
CISDM/UMASS-Amherst 21
Performance: EACM Hedge Fund Strategies and Traditional Assets (January 1990-December 2002)
Return Standard Sharpe Minimum Correlation with Correlation withDeviation Ratio Monthly Return S&P 500 Lehman Bond
Relative Value
Market Neutral 8.50% 3.21% 1.16 -2.62% -0.17 0.18Convertible Hedge 9.76% 5.27% 0.95 -6.90% 0.17 0.04Bond Hedge 6.30% 4.78% 0.32 -7.09% 0.18 -0.10Rotational 14.23% 6.35% 1.49 -13.98% 0.07 -0.14
Event Driven
Arbitrage 8.56% 6.06% 0.63 -11.10% 0.49 0.11Bankruptcy 13.48% 6.43% 1.35 -8.17% 0.34 0.02Multi-Strategy 13.94% 5.26% 1.75 -8.29% 0.46 0.03
Equity Hedge
Domestic Long 12.53% 15.41% 0.50 -15.11% 0.69 0.07Long/Short 16.11% 10.03% 1.13 -5.15% 0.24 -0.01Global/International 15.63% 10.94% 0.99 -9.17% 0.60 0.11
Global Asset Allocators
Discretionary 14.07% 9.19% 1.01 -15.87% 0.33 0.08Systematic 17.21% 16.20% 0.77 -9.85% -0.10 0.26
Short Selling 1.75% 22.11% -0.14 -12.99% -0.78 -0.06
S&P 500 9.68% 15.28% 0.32 -14.46% 1.00 0.16Lehman Bond Index 8.30% 4.25% 0.83 -2.45% 0.16 1.00
Hedge Fund Performance
CISDM/UMASS-Amherst 22
Factor Correlations (January 1996-December 2002)
S&P 500 Lehman Bond Lehman Volatility ProxyIndex High Yield Equity
EACM 100 0.49 0.01 0.47 -0.34Relative Value 0.16 -0.22 0.40 -0.10
Market Neutral -0.16 0.18 -0.03 0.30Convertible Hedge 0.23 -0.09 0.46 -0.13Bond Hedge 0.18 -0.23 0.38 -0.14Rotational 0.09 -0.28 0.21 -0.13
Event Driven 0.53 -0.15 0.63 -0.50
Arbitrage 0.53 -0.14 0.61 -0.54Bankruptcy 0.44 -0.15 0.56 -0.40Multi-Strategy 0.50 -0.13 0.59 -0.47
Equity Hedge 0.61 -0.10 0.43 -0.42Domestic Long 0.67 -0.07 0.47 -0.49
Long/Short 0.32 -0.10 0.22 -0.23Global/International 0.58 -0.10 0.42 -0.35
Global Asset Allocators 0.23 0.39 0.18 -0.14
Discretionary 0.53 0.05 0.49 -0.49Systematic -0.09 0.47 -0.13 0.18
Basis for Hedge Fund Performance
CISDM/UMASS-Amherst 23
Tracking Factor Based Determinants of Hedge Fund Returns– US Case
EACM 100 Factor Replicating PortfolioTwenty-Four Montsh Rolling Regression
-6%
-4%
-2%
0%
2%
4%
6%
EACM 100 Replicating Portfolio
In Sample Regression results
Average Value of Estimated Coefficient
RSQ 0.444Intercept 0.004S&P 500 Total Return Index 0.09Lehman U.S. Government/Credit -0.107
Lehman U.S. Corporate High Yield 0.342Straddle S&P100 0.000
Out of Sample Statistics (1/96-3/03) Mean StdevEACM 100 8.23% 4.89%Replicating Portfolio 4.05% 4.29%Error Term 4.18% 4.46%Correlation 53%
CISDM/UMASS-Amherst 24
European Hedge Fund: Factor Analysis – Tracking
Europe: Hennesee Europe Index Factor Replication
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
Hennessee Europe Index Replicating Portfolio
In Sample Regression results
Average Value of Estimated Coefficient
RSQ 0.599Intercept 0.010DJ EURO STOXX 50 0.43FTSE 100 Future -0.151
Merrill Lynch EMU Corporates, BBB Rated 0.617Merrill Lynch EMU Direct Governments, 10+ Yrs -0.252Straddle Return FTSE 100 (UKX) 0.002Straddle Return DJ EURO STOXX 50 (SX5E) 0.019
Out of Sample Statistics Mean StdevHennessee Europe Index -2.96% 3.35%Replicating Portfolio -7.05% 7.61%Error Term 4.09% 6.96%Correlation 40%
CISDM/UMASS-Amherst 25
Long/Short: Factor Analysis – Tracking
In Sample Regression results
Average Value of Estimated Coefficient
RSQ 0.652Intercept 0.013DJ EURO STOXX 50 0.43FTSE 100 Future -0.194
Merrill Lynch EMU Corporates, BBB Rated 0.391Merrill Lynch EMU Direct Governments, 10+ Yrs -0.166Straddle Return FTSE 100 (UKX) 0.009Straddle Return DJ EURO STOXX 50 (SX5E) 0.014
Out of Sample Statistics Mean StdevLong/Short Portfolio (Euro) -0.61% 3.47%Replicating Portfolio -8.02% 7.56%Error Term 7.41% 6.85%Correlation 43%
Europe: Long/Short Factor Replication
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
Long/Short Portfolio (Euro) Replicating Portfolio
CISDM/UMASS-Amherst 26
Tracking Style Based Determinants of Hedge Fund Returns US Case
EACM Hedge Equity Style Replicating PortfolioTwenty-Four Montsh Rolling Regression
-10%
-5%
0%
5%
10%
15%
20%
Jan-
97
Apr-9
7
Jul-9
7
Oct-97
Jan-
98
Apr-9
8
Jul-9
8
Oct-98
Jan-
99
Apr-9
9
Jul-9
9
Oct-99
Jan-
00
Apr-0
0
Jul-0
0
Oct-00
Jan-
01
Apr-0
1
Jul-0
1
Oct-01
Jan-
02
Apr-0
2
Jul-0
2
Oct-02
Jan-
03
EACM Equity Hedge Domestic Opportunistic Replicating Portfolio
In Sample Regression results
Average Value of Estimated Coefficient
RSQ 0.533Intercept 0.008S&P 500 Total Return Index -0.20Russell 2000 0.487
Out of Sample Statistics (1/96-3/03) Mean StdevEACM Equity Hedge Domestic Opportunistic12.40% 11.97%Replicating Portfolio 4.52% 9.63%Error Term 7.88% 9.67%Correlation 62%
CISDM/UMASS-Amherst 27
Hedge Funds: Style Based Long Short Equity Tracking
Tracking: Dow Jones Euro Stoxx 50, FTSE 100
Europe: Long-Short Style Replication
-6%
-4%
-2%
0%
2%
4%
6%
Long/Short Portfolio (Euro) Replicating Portfolio
In Sample Regression results
Average Value of Estimated Coefficient
RSQ 0.509Intercept 0.006DJ EURO STOXX 50 Future 0.32FTSE 100 Future -0.117
Out of Sample Statistics Mean StdevLong/Short Portfolio (Euro) -0.61% 3.47%Replicating Portfolio -5.66% 7.11%Error Term 5.05% 6.22%Correlation 48%
CISDM/UMASS-Amherst 28
Asset Allocation: Active Asset Management
•Strategic Asset Replacement
•Tactical Asset Management
CISDM/UMASS-Amherst 29
Hedge Funds in Active Asset Allocation
Portfolio Risk and Return Contribution
Stock Portfolio High Grade Bond Portfolio High YIeld Bond Portfolio
Hedge Fund Strategy
Market Neutral Equity Risk Diversifier Return Enhancer Risk Diversifier
Fixed Income Arbitrage Risk Diversifier Risk Diversifier Return Enhancer
Convertible Arbitrage Mixed Risk Diversifier Return Enhancer
Event Return Enhancer Risk Diversifier Return Enhancer
Merger Arbitrage Return Enhancer Risk Diversifier Return Enhancer
Distressed Return Enhancer Risk Diversifier Return Enhancer
Hedge Equity Return Enhancer Risk Diversifier Return Enhancer
CTA High Risk-Return/ Risk Diversifier High Risk-Return/ Risk Diversifier High Risk-Return/ Risk Diversifier
CISDM/UMASS-Amherst 30
Traditional Mean Variance Optimization with Hedge Funds
Traditional Asset Classes Weights Sub TotalU.S. 30 Day TBill TR 5.0%
SB 1 Yr On-The-Run Treasury TR 5.0% 10%SB 3-7 Yr Treasury TR 5.0%SB 10+ Yr Treasury TR 10.0%
SB Hi-Yld TR 5.0%SB AAA/AA Corp TR 10.0% 30%
Russell 1000 TR 40.0%Russell 2000 TR 10.0% 50%MSCI EAFE TR 5.0%
MSCI Emerging Market Free USD5.0% 10%
CISDM/UMASS-Amherst 31
Hedge Funds Replace Traditional Assets Change in Allocation
U.S. 30 Day Tbill TR (Total Return) -3.7% -3.5% -3.7% -4.5% -4.1%SB 3-7 YR Treasury TR (Total Return) 0.0% 0.0% 0.0% 0.0% -0.5%SB 10+ Tr Treasury TR (Total Return) 0.0% 0.0% -0.6% 0.0% -0.1%SB Hi-Yld TR (Total Return) -1.0% -1.3% -0.1% -0.3% 0.0%Russell 1000 TR (Total Return) 0.0% 0.0% -0.5% 0.0% 0.0%Russell 2000 TR (Total Return) -0.3% -0.1% 0.0% 0.0% -0.2%MSCI EAFE TR (Total Return) 0.0% 0.0% 0.0% 0.0% 0.0%MSCI Emerging Markets Free USD -0.1% -0.1% 0.0% -0.2% 0.0%
HFRI Relative Value Arbitrage Index 5.0%HFRI Convertible Arbitrage Index 5.0%HFRI Statistical Arbitrage Index 5.0%HFRI Fixed Income: Arbitrage Index 5.0%HFRI Equity Market Neutral Index 5.0%
Annualized Mean of Port With Hedge Fund 11.23% 11.13% 11.09% 11.05% 11.14%Annualized Std of Port With Hedge Fund 9.43% 9.43% 9.43% 9.39% 9.43%Annualized Mean of Trad Asset Class 10.88% 10.88% 10.88% 10.88% 10.88%Annualized Std of Trad Asset Class 9.43% 9.43% 9.43% 9.43% 9.43%
CISDM/UMASS-Amherst 32
Hedge Funds Replace Traditional Assets Change in Allocation
U.S. 30 Day Tbill TR (Total Return) -1.1% -3.6% -2.0% -2.7%SB 3-7 YR Treasury TR (Total Return) 0.0% 0.0% 0.0% 0.0%SB 10+ Tr Treasury TR (Total Return) -1.9% 0.0% 0.0% 0.0%SB Hi-Yld TR (Total Return) -0.7% -0.9% -2.4% 0.0%Russell 1000 TR (Total Return) 0.0% -0.1% 0.0% -0.1%Russell 2000 TR (Total Return) -0.5% -0.4% -0.4% -1.9%MSCI EAFE TR (Total Return) -0.1% 0.0% 0.0% -0.2%MSCI Emerging Markets Free USD -0.6% 0.0% -0.3% -0.1%
HFRI Macro Index 5.0%HFRI Merger Arbitrage Index 5.0%HFRI Distressed Securities Index 5.0%HFRI Equity Hedge Index 5.0%
Annualized Mean of Port With Hedge Fund 11.32% 11.17% 11.21% 11.49%Annualized Std of Port With Hedge Fund 9.43% 9.43% 9.41% 9.44%Annualized Mean of Trad Asset Class 10.88% 10.88% 10.88% 10.88%Annualized Std of Trad Asset Class 9.43% 9.43% 9.43% 9.43%
CISDM/UMASS-Amherst 33
Ranked by S&P 500 Returns (1990-2002)
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
1 2 3 4
Av
era
ge M
on
thy
Ret
urn
fo
r R
an
ke
d P
ortf
olio
s
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
S&
P 5
00
HFR Convertible Arbitrage Index HFR Equity Hedge Index HFR Event Driven Index
HFR Distressed Securities Index HFR Merger Arbitrage Index HFR Equity Market Neutral Index
HFR Fixed Income Arbitrage Index HFR Relative Value Arbitrage Index HFR Statistical Arbitrage Index
S&P 500 Total Return Index
Hedge Fund Selection Determined By Economic Forecast
CISDM/UMASS-Amherst 34
Ranked by Lehman US Aggregate Returns (1990-2002)
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
1 2 3 4
Ave
rag
e M
on
thly
Ret
urn
fo
r R
anke
d P
ort
folio
HFR Convertible Arbitrage Index HFR Equity Hedge Index HFR Event Driven Index
HFR Distressed Securities Index HFR Merger Arbitrage Index HFR Equity Market Neutral Index
HFR Fixed Income Arbitrage Index HFR Relative Value Arbitrage Index HFR Statistical Arbitrage Index
Lehman U.S. Aggregate
Tactical Asset Allocation: Hedge Fund Selection by Economic Forecast
CISDM/UMASS-Amherst 35
Conclusions
Risk and Return Analysis That Works for Traditional Assets Works for Hedge Fund Analysis.
Hedge Funds and CTAs Provide Risk And Return Opportunities Consistent With Their Exposure To Various Market Opportunities as well as Trader Skill.
Modern Methods Of Asset Allocation That are Used To Determine Source of Return To Stocks and Bonds Can Be Used To Determine Source of Returns to Hedge Funds.