Post on 19-Aug-2020
transcript
Absolute Return Strategies
TWST: Please start with an overview of Arrow
Funds. Tell us all about its investment philosophy and what
you do there.
Mr. Flaig: Arrow Funds is one of the fasting growing
investment management companies in the industry. The company
was formed in early 2006 and launched its first product, the
Arrow DWA Balanced Fund, in August of that year. We’ve had
great success with that product — it exceeded $100 million in
AUM right after its one-year anniversary. Over the last year, the
Fund has continued to outperform 90% of the funds in the Morn-
ingstar moderate asset allocation category.
Arrow’s vision is to manufacture and distribute alterna-
tive investment solutions for financial intermediaries and their
clients. The Arrow founders are made up of the original product
development team at Rydex Investments. They worked together
for a number of years as a team, developing and distributing mu-
tual funds, ETFs, variable trust funds and WRAP programs. The
business lines and products they created were instrumental com-
ponents to the recent sale of Rydex. I met this team when I was
the Director of Portfolio Management at Rydex. I joined Arrow
Funds earlier this year, in the capacity of Chief Investment Offi-
cer, with a mandate to enhance the firm’s manufacturing capabil-
ity of absolute return strategies and oversee other investment
initiatives. Absolute return strategies aim to produce positive re-
turns in as many environments as possible.
In a declining market, successfully implemented abso-
lute return strategies aspire to provide positive returns, or to avoid
or hedge market risk. To this end, absolute return strategies may
use hedging, short selling, or for arbitrage or other positions less
dependent on broad market direction. In a declining market, a
relative return strategy, which is designed to track an index, will
track the index down — the manager, who typically has a man-
date to stay invested, hopes to marginally outperform on the
downside. Conversely, in a rising market, the relative return man-
ager benefits from the rising tide of its asset class. The manager
may or may not participate in such a rise, depending on whether
William E. Flaig Jr., Chief Investment Officer at Arrow Investment Advisors, LLC, joined the firm in February
2007. He spent five years at Rydex Investments, working as Director of Portfolio Management, in which he managed
the entire portfolio team. While at Rydex, Mr. Flaig defined the concept of hedge fund replication, initiated the
research and investment strategies on which the Rydex Absolute Return Strategies Fund and the Rydex Hedge
Equity Fund are based, and directed those strategies. He also developed best practices for creating leverage within
the constraints of a mutual fund offering unlimited trading. Prior to Rydex, he spent six years at Bankers Trust
Company in a range of roles including currency trading, proprietary trading, derivatives structuring, emerging
market fixed-income, and currency trading. He graduated from Purdue University with a degree in Management.
M O N E Y M A N A G E R I N T E R V I E W
R E P R I N T E D F R O M N O V E M b E R 1 9 , 2 0 0 7
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
his strategy is correlated to or hedged against the rising asset
class, and whether or not the sources of the absolute return strat-
egy’s returns and risk are related to that asset class.
Absolute and relative returns are different from each
other and widely varied among themselves. Stock and bond
funds, while both relative return strategies, are as different from
each other as long/short equity are from fixed income arbitrage
among absolute return strategies. We plan to deliver 1940 Act
products that make use of these differences. By doing so, we will
provide mutual fund investors with an array of tools comparable
to that available to institutional investors. We would love to put
the mutual funds on a more equal footing with endowments by
providing similar product objectives and nontraditional sources
for returns, greater opportunities for diversification and tools for
risk management. Our first absolute return strategy vehicle is
called the Arrow Alternative Solutions Fund.
TWST: Tell us about some of these alternative invest-
ment strategies that you brought to the firm and how that ties
in with the Aternative Solutions Fund.
Mr. Flaig: I will speak to my background a little bit
before I go into that. Prior to working at Rydex, I had extensive
experience at Bankers Trust with investment strategies and assets
that ran the gamut from fixed income, equities, global fixed in-
come, and currencies to derivatives trading and structuring. This
helped me acquire insight and expertise into the instruments used
in alternative strategies. My experience at Rydex, which is pri-
marily an equity indexing shop that uses derivatives extensively,
afforded the opportunity to hone the practical application of these
instruments for mutual funds. As the Director of Portfolio at
Rydex, I was responsible for the management of $10 billion
spread over several unique investment strategies. I was signifi-
cantly involved in building and then refining the firm’s quantita-
tive investment process. Also, I extensively researched and
developed the concept and framework for Rydex’s hedge fund
replication strategies.
I left Rydex to research and develop a better alternative
value proposition. While the roots of my replication research
helped, I’ve spent the last 18 months developing another alterna-
tive approach. The Arrow Alternative Solution Fund is a major
step forward because it combines some of the principles of hedge
fund replication with modern portfolio theory. At Arrow, I’ve
developed several absolute return factors, which go beyond tradi-
tional investment methodologies because they attempt to reduce
correlation to the risk of a given asset class.
Whether or not to favor relative return factors or abso-
lute return factors, and how to apply those factors, are questions
strongly influenced by the efficient market debate. I believe that
the bulk of traditional returns are driven by exposure to relative
return factors. Because a relative return factor behaves with high
correlation to and within its asset class, it has no mechanism to
control downside risk during cyclical negative market periods.
Therefore, relative return factors contain market risk. Tradition-
ally, investors have attempted to mitigate the risk inherent in
relative return factors by creating diversified portfolios, which
may allocate between stocks and bonds, between domestic and
international stocks, between growth and value stocks, or be-
tween stocks of different capitalization ranges and different sec-
tors. I believe that the ultimate goal of diversification — to
combine assets that move independently of one another — has
not been satisfactorily achieved by traditional approaches. My
approach combines these absolute return factors to create a core
alternative portfolio. This kind of portfolio construction is opti-
mal for seeking absolute returns and capital appreciation with
low volatility and low correlation to the equity markets.
“The Fund’s principle investment strategy seeks to maximize returns from a diversified portfolio of three long and short strategies with a targeted risk objective. We are looking to achieve a total rate of return that meets or exceeds 10% per year after management fees over a rolling three- to five-year time horizon, with a risk target of 7% as measured by annual standard deviation, and a beta to the S&P 500 of less than 0.5.”
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
The Fund’s principle investment strategy seeks to maxi-
mize returns from a diversified portfolio of three long and short
strategies with a targeted risk objective. We are looking to
achieve a total rate of return that meets or exceeds 10% per year
after management fees over a rolling three- to five-year time ho-
rizon, with a risk target of 7% as measured by annual standard
deviation, and a beta to the S&P 500 of less than 0.5. As with any
fund, let me state that we do not represent or guarantee that the
Fund will meet these goals.
TWST: The Alternative Solutions Fund seems to
combine features of mutual funds and hedge funds. Is that
correct and, if so, what are the differences?
Mr. Flaig: You’re correct, the Fund does combine fea-
tures of mutual funds and hedge funds. The markets are a catalyst
for change and so is market regulation. The mutual fund industry
is always looking for way to preserve its own income stream as
well as investor capital. Their foray into the hedge fund space
started in 1997 when Congress repealed the mutual fund short-
short rule. Congress believed it would be in the public interest if
mutual funds could trade (and hedge) more broadly and effectively.
Rydex delivered the first inverse strategies that were tied to indices
like the S&P 500. These funds became great hedging tools for the
tactically proficient investor. Other manufacturers created dedi-
cated long/short strategies and now some are utilizing strategies
designed to mirror the performance of hedge fund indices.
More specifically, the Arrow Alternative Solutions Fund
is a mutual fund structure with hedge fund features. Hedge funds
have long been highly regarded for their use of alternative strategies
and investment techniques. However, the structure of the hedge
funds themselves often raises concerns for investors. Historically,
the mutual fund industry has been oriented to long-only investing.
This orientation has proven costly, especially since 1999. The fu-
ture demands a more varied investment approach in order to pre-
serve and enhance capital for a generation of investors.
The Arrow Alternative Solutions Fund seeks to combine
the best features of hedge funds and mutual funds. Some of the
shared characteristics compared would be that hedge funds and
long/short mutual funds are both seeking absolute returns — that
is, positive returns regardless of the market environment — while
traditional mutual funds are generally just seeking returns relative
to benchmarks that have periods of outperformance and underper-
formance. Traditional mutual funds typically have high correla-
tions to equity and bond markets while the Arrow Alternative
Solutions Fund and hedge funds have low correlations to equities
and the bond market. Mutual funds are highly regulated with over-
sight from the SEC, while hedge funds operate in an environment
with far less regulation. Mutual funds have restrictions on leverage,
illiquid securities, and derivatives; limitations on incentive fees;
and protective custody requirements. These restrictions keep some
of the problems found in the hedge fund away. Mutual funds are
highly transparent and they offer liquidity through the daily NAV.
Most hedge funds pride themselves on not being transparent and
they limit the frequency of investor redemptions. Another major
difference is the structure of managers’ compensation. Mutual
fund companies charge fees from 1% to 4.5% on the amount of
assets under management, regardless of performance (in the case
of the Arrow Alternative Solutions Fund, the fee is 1.52%). Most
hedge fund companies charge flat management fees of 1% to 2%
based on the total assets under management plus 20% to 25% in-
centive fees. Aside from the hedge funds’ high fees and lack of
oversight, the next biggest barriers to purchase are investor qualifi-
cations and high minimums.
“The Arrow Alternative Solutions Fund is a mutual fund structure with hedge fund features. Hedge funds have long been highly regarded for their use of alternate strategies and investment techniques. However, the structure of the hedge funds themselves often raises concerns for investors. Historically, the mutual fund industry has been oriented to long-only investing. This orientation has proven costly, especially since 1999. The future demands a more varied investment approach in order to preserve and enhance capital for a generation of investors.”
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
Hedge funds are restricted to accredited investors and
they typically have investment minimum that range between
$100,000 to $1,000,000. Mutual funds are open to all investors.
While most funds do have minimums, these minimums range
between $1,000 and $10,000. Our Fund’s non-qualified mini-
mum is $5,000 and $2,000 for retirement accounts.
Offering a more diversified and robust portfolio that can
preserve and enhance capital over time in all market environ-
ments is something that only a very few have had access to in the
past. The Arrow Alternative Solutions Fund was designed so that
all investors can have access to a low cost, highly diversified
absolute return strategy. It’s indeed the best of both worlds.
TWST: Tell us about the allocation of your different
strategies and the composition of the Fund?
Mr. Flaig: The Arrow Alternative Solutions Fund pro-
vides exposure to three long/short strategies, including hedged
equities, fixed income arbitrage and managed futures. The goal
of each long/short strategy is to systematically identify and pro-
vide exposure to absolute return factors on an ongoing basis. The
hedged equity strategy seeks to generate returns from investing
on both the long and short sides of equity markets while main-
taining a low correlation to the US equity market. The hedged
equity strategy will provide exposure to eight absolute return fac-
tors (e.g. long/short value). The Fund could have between 40%
and 60% exposure to this strategy.
The fixed income arbitrage strategy seeks to generate
returns from relationships between different fixed income securi-
ties, employing long and short positions to minimize exposure to
interest rate changes that are either mathematically or historically
interrelated. The strategy will provide exposure to five absolute
return factors (e.g. high yield credit spread). The Fund could have
between 20% and 45% exposure to this strategy.
The managed futures strategy seeks to generate returns
from convergent and divergent trends in the commodity, financial
and currency futures markets. The Fund could have between 20%
and 30% exposure to this strategy. The managed futures strategy
will provide exposure to four absolute return factors (e.g. long/
short commodity sector relative strength). The allocation among
the strategies is determined with a portfolio optimization tool to
maintain targeted risk of 7%.
The Fund has several long/short portfolios but there is
ultimately an underlying investment rationale that supports why
the absolute return factor has historically had positive perfor-
mance and why we would expect that performance to continue in
the future. I speak to this in a
white paper that we’ve devel-
oped, and each investment ratio-
nale is supported by industry
practice and academic research.
TWST: Do the three
long/short investment strate-
gies, your three buckets, all in-
clude the absolute return factors
you mentioned previously?
Absolute Return Factors for each Strategy
“The Alternative Solutions Fund provides exposure to three long/short strategies, including hedged equities, fixed income arbitrage and managed futures. The goal of each long/short strategy is to systematically identify and provide exposure to absolute return factors on an ongoing basis. The hedged equity strategy seeks to generate returns from investing on both the long and short sides of equity markets while maintaining a low correlation to the US equity market.”
M O N E Y M A N A G E R I N T E R V I E W ——————— I N V E s T I N G I N s T O c k s
Mr. Flaig: They do. Since absolute return factors are
being pioneered by Arrow Funds and it’s not a widely publicized
concept, I think it would be helpful to explain what they are.
Absolute return factors go beyond traditional invest-
ment methodologies in an attempt to reduce correlation to the
risk of their asset class. The objective is to deliver the return of
a particular investment style, while reducing that style’s overall
and market risk, thus reducing portfolio volatility over time.
We use a quantitative methodology to identify two subsets
within each absolute return factor: those assets expected to
outperform the asset class, which are held long; and, those ex-
pected to underperform the asset class, which are sold short.
This long/short portfolio construction attempts to minimize
the risk of substantial losses stemming from market declines
while reducing volatility.
Each absolute return factor is tied to a very common
hedge fund strategy. The long/short value is an absolute return
factor in the Fund’s hedged equity strategy. I use this as an illus-
tration because almost all investors have a value exposure in their
portfolio. Another very commonly held exposure in portfolios is
size. This is based on research done by many, but particularly
Fama and French, who validated the idea that value and small
companies historically outperformed the marketplace. The ratio-
nale for why they outperformed the overall market is that an in-
vestor is taking more risk in a value company or a small cap
company. The investor is compensated for this greater risk with a
greater return, so risk reward supports why investors, from an
academic standpoint, include value in their portfolios and why
investors include small cap in their portfolios.
Since the early 1990s, this has been a generally ac-
cepted investment philosophy and people have been allocating
to these styles accordingly. That’s the starting point for an ab-
solute return factor, but when an investor buys value or buys
small cap he is also just getting equity market risk or equity risk
premium as well in his investment. You will still have years
where even a value holding or a small cap holding will lose
money if the overall equity market is down. The return is al-
ways going to be relative to that equity risk premium and if you
look at the correlation to the S&P 500, value and size investing
is high—higher than 0.8 and very likely higher than 0.9. The
Fund’s long/short portfolio construction and the absolute return
factor philosophy are applied to a value basket. The absolute
return factor that provides exposure to value will buy value
stocks just like traditional investors but we simultaneously pur-
chase a portfolio of non-value stocks against the long basket.
What is produced is the absolute return of value and not
the relative return of value. By doing that, we are reducing the
equity exposure, emphasizing the value exposure in a more pure
way. This is the simple building block behind the Fund’s absolute
return factors.
This long/short portfolio construction is applied to
many of the same traditional investment styles that are used by
investors today. The Fund will be long a broad mix of finan-
cial asset classes, including equities, fixed income, currencies
and commodities. The Fund will be short the same broad mix
of financial asset classes using derivatives. Most long/short
strategies focus on one or multiple absolute return factors.
Some focus on just equities, fixed income or commodities.
The individual exposures are rarely combined. However,
hedge fund of funds strategies will combine them. How they
are combined is their downfall. Isolating those traditional in-
vestment styles into a corresponding absolute return factor is
critical to our approach. Our value proposition is how we com-
bine these factors.
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
“The managed futures strategy seeks to generate returns from convergent and divergent trends in the commodity, financial and currency futures markets. The Fund could have between 20% and 30% exposure to this strategy. The managed futures strategy will provide exposure to four absolute return factors (e.g. long/short commodity sector relative strength). The allocation among the strategies is determined with a portfolio optimization tool to maintain targeted risk of 7%.”
M O N E Y M A N A G E R I N T E R V I E W ——————— I N V E s T I N G I N s T O c k sM O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
TWST: How are you able to get a performance re-
cord for such diverse strategies? What is the comparison you
use to measure performance?
Mr. Flaig: I spent the last 18 months testing each ab-
solute return factor. I have elaborated on this in a white paper.
In the paper, we use only third-party data to be able to test the
strategy both historically and transparently. Because of data
quality, we limited the overall backtest, but I have personally
tested equity absolute return back to 1927. There are obvious
data limitations on the fixed income and commodity data set for
our testing, but we backtested the Fund’s strategy with third-
party data back to 1995. Because there are practical limits that
come with third-party data, we produced our own proprietary
historical return stream for each absolute return factor. This
data set was created to help our implementation and manage-
ment of the Arrow Alternative Solutions Fund. We are also
happy to report that the conclusions were essentially the same
when we compared the two data sets.
What we’ve created is very exciting. The Arrow Alterna-
tive Strategy was tested back to 1995 has offered an annual return
of 14% with a risk of about 6%. This is an excellent risk-adjusted
return when compared to traditional assets. The beta to the S&P
500 over that time period was about a 0.13, and a .46 Sharpe ratio.
What was really telling was how the strategy performed over the
worst and best three year period since 2000. Between April 2000
and March 2003 the S&P 500 lost an annualized 16.1% with a
standard deviation of more than 17%. During that time period, the
alternative strategy was up about 13%, again, with a 6.3% standard
deviation. Between April 2003 and March 2006 the S&P 500 was
up 17% annualized with a standard deviation of 8.8%. During that
time period, the alternative strategy was close to 13%, again, with
a 6.5% standard deviation. While the S&P 500 was nearly flat over
the combined period, the Arrow Alternative Strategy annualized
return was more than 12% and less risk and very little correlation.
In an environment when the S&P 500 is doing very well or an
environment when the S&P 500 is doing poorly, this Fund’s back-
tested performance has been stable. We’ve seen strong returns with
a very controlled level of risk and a low beta to the S&P 500. So
from a big picture perspective, if you think of a portfolio as the
efficient frontier as we’ve all been taught, adding this strategy to a
portfolio bumps the efficient frontier out to what’s commonly
called the northwest quadrant: more return for either the same or
less risk to the positive attribute.
If you look at it
over a complete market
cycle, in years when tradi-
tional investments are
struggling, this strategy is
performing extremely well,
and in years when the S&P
or bonds are strong, this
strategy is also keeping up
— it’s still on the efficient
frontier. From the diversifi-
cation standpoint, you are
getting strong performance
and diversification in bear
markets, which is when you
need it most, and the cost of
doing it is minimal because
it’s still on the efficient
frontier in strong market
environments.
Historical Look at the Arrow Alternative Strategy
M O N E Y M A N A G E R I N T E R V I E W ——————— I N V E s T I N G I N s T O c k s
TWST: Are there any other risk management tech-
niques that you incorporate into the strategies that you can
tell us about?
Mr. Flaig: I would like to keep that simple. In our optimi-
zation approach, we are targeting a fixed level of risk as opposed to
an asset-based target. That’s an extremely strong value proposition.
We do have diversification constraints in place to prevent the Fund
from piling into one strategy at any given time. We also have the risk
constraint: for an absolute return strategy even to be considered in
the Fund, it has to have a compelling historical risk towards justifica-
tion supported by research beyond our own institution with a strong
enough investment rationale that would convince us that the strate-
gy’s compelling performance would continue in the future.
We have several additional risk controls that are inher-
ent to mutual funds themselves. Also, from a portfolio construc-
tion standpoint, think of the extent that a long/short strategy is
leveraged. We are buying long exposure that’s greater than the
Fund’s assets and we’re creating short exposure, which is also
significant. The level of that overall exposure is constrained so
that we can’t get runaway leverage and the amount of net expo-
sure, which is the long minus the short exposure, has to be below
0.8 as well. The Fund has to be long/short and not overly lever-
aged — these risk controls are laid out in the Fund’s prospectus.
As mentioned earlier, alternative strategies have posted
strong returns with lower volatility than their stock and bond coun-
terparts. But to round out that picture, it’s necessary to consider that
volatility is not the only measure of risk a client could face. Volatility
takes into account what normally happens, but it doesn’t reflect just
how far outside the normal distribution the returns can be. For that
we looked at the risk band — that is, the peak, median and low.
The alternative strategy does a satisfactory job of
achieving its 7% risk objective when we evaluated the rolling
three-year average from January 1995 though September 2007.
The risk band is narrower than the equity market and most of the
hedge fund proxies that we put it against. Looking at the 36-
month rolling standard deviation and return, we discovered what
you would expect for the S&P 500. The S&P 500 risk band
ranged between 7.6% and 22.2% with average risk of 16.7% and
average return of 10.9%. When compared to credit Suisse Trem-
ont Hedge Fund Index, the risk band was smaller — 3.1% to
12.9% — but it had lower average risk of 8.4% and slightly lower
returns of 10.3%. However, the risk band for the alternative strat-
egy was tighter and similar to a bond portfolio (between 6% and
7.6% with an average risk of 7.1% and a 13.3% return). This was
higher than both. The Credit Suisse Tremont Hedge Fund Index
performance was in line with our strategy but its risk band re-
sembled the equity markets — it had a beta of.50 and risk average
of 10.3%, similar to a traditional 60% equity and 40% bond port-
folio. The average beta for the alternative strategy was 0.16.
TWST: What gives this Alternative Solutions Fund its
edge? What are the defining features that you think makes it
distinctive compared with other al-
ternative strategies at other firms?
Mr. Flaig: The diversifi-
cation across multiple hedge fund
strategies and the specific risk tar-
get of 7% are competitive advan-
tages. The Fund is combining three
systematic long/short strategies is
also an advantage over black-box
type construction methodologies
used by others. Lastly, the fund is
not backward looking — that is,
looking at what hedge fund indexes
or hedge fund holdings have been.
It is only forward-looking in its
portfolio construction.
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
Risk Band for Various Market Indicators
M O N E Y M A N A G E R I N T E R V I E W ——————— I N V E s T I N G I N s T O c k s
If I compare those advantages to groups of other alterna-
tive products in the marketplace, the Arrow Alternative Solutions
Fund has better diversification and better risk controls than funds
that are offering hedge fund replication (that is, a high correlation
to hedge fund indexes); additionally, it is not a black box and is
not looking backward at hedge fund indexes.
When I look at this fund versus hedge funds of funds or
mutual funds that invest in hedge fund subaccounts, the Arrow
Alternative Solutions Fund has superior diversification and risk
controls. We also do not have manager risk or capacity con-
straints that might exist in some of those funds.
Many of those funds are allocating to small hedge fund
managers, a process that does not have scalability. This is be-
cause as hedge fund managers get bigger, their performance
tends to deteriorate. Not unlike in the mutual fund space, the
niche is somewhat dependent upon liquidity and small size to be
able to deliver that value proposition.
The Arrow Alternative Solutions Fund may not have
scalability problems, so it will not have limits as to how much it
can grow without a deterioration of performance. And lastly,
against long/short strategies that are proliferating in the market-
place, most of them are not diversified; they are actually nar-
rowly focused on a particular investment style. They don’t have
diversification, they have manager risks, and a lot them are focus-
ing on what I would call the, 120-20, 130-30 type of long/short
portfolio construction, which is very different from the portfolio
construction used in this Fund. You should note that a lot of these
funds struggled in the volatile market over the summer of 2007.
In 120-20 portfolio construction, the manager buys $1.20 of long
exposure for every dollar of investor money and creates the 0.2
short exposure. This structure gives the manager leverage to beat
a benchmark, but it does not lower portfolio’s correlation to the
S&P 500. The portfolio’s 120% long exposure minus 20% short
exposure has 100% net long exposure, which is why its correla-
tion to the S&P 500 is higher.
Our fund’s portfolio net exposure will not be 100% net
long. In fact, historically the strategy will have $1.50 of long ex-
posure and $1 of short exposure — 150% long exposure minus
100% short exposure has 50% net exposure. That is half of the
overall market exposure. The net exposure will range between
50% and 80%, which is driven by our optimization process.
Tools that provide lower correlation to the traditional equity mar-
ket are better vehicles to diversify traditional portfolios.
Most people don’t realize that risk in hedge funds and
active manager is driven by the parameter of the corresponding
manger’s opportunity to seek potentially higher returns and not
by the investor’s risk tolerance.
The risk-targeting concept can also be thought of as risk
rebalancing. Ultimately, an investor’s risk tolerance is fixed over
most time periods and likely decreases as he or she ages, holding
other variables constant. This is not in conjunction with what
most investors actually hold in their portfolios (an asset mix of
60/40, 40/60 etc.,), which varies widely over time.
The conventional asset allocation portfolio’s riskiness is
independent of the investor’s risk tolerance. Regardless of their
risk tolerance, investors are taking more risk when the market is
riskier and taking less risk when the market is less risky. With the
targeted risk approach I propose, the investor is conceptually
buying more of the relatively riskier assets during periods of low
overall risk and buying more of the least relatively risky assets
during periods of high overall risk.
TWST: Though this fund might not be suitable for
all investors, would you give us a description of your typical
clients who are interested in alternative strategies?
Mr. Flaig: A majority of our investors will be financial
intermediaries. Most of these intermediaries are turning to tacti-
cal and alternative strategies to increase diversification, boost
returns, and help manage risk. If the investor’s goal is to secure
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
Long / Short Portfolio Exposure
M O N E Y M A N A G E R I N T E R V I E W ——————— I N V E s T I N G I N s T O c k s
higher returns at a lower risk, then integrating the Arrow Alterna-
tive Solutions Fund into a traditional portfolio should help reduce
portfolio volatility and improve the odds of preserving capital
over the long term.
Allocation to alternative assets is a strategy that many
endowment managers (e.g. Harvard, Yale) are utilizing today.
Prior to 1999, Harvard’s investing was strictly limited to US
stocks, bonds and cash. They recognized they were taking on too
much risk and missed out on opportunities with alternative as-
sets. Since 1999 they gradually started to shift away from tradi-
tional assets toward “absolute return” assets. Today, Harvard
allocates 17% toward alternative assets and most endowments are
allocating between 10% and 25%. These asset classes have the
potential to deliver “equity-like” returns, but since they are not
correlated with US equities, they cushion the portfolio against
losses when the domestic stock market goes through its inevitable
down cycles.
One of our goals is to create value for our clients by offer-
ing investment strategies that seek to enhance returns and mitigate
risk. Our first product, The Arrow DWA Balanced Fund, tactically
provides exposure to four market segments (US equities, interna-
tional equities, fixed income and alternative assets). Our tactical
core is designed to be responsive to changing market conditions but
it is missing exposure to “absolute return” strategies. The Arrow
Alternative Solutions Fund enables clients to blend our tactical core
product with a fund with absolute return strategies to create their
own endowment solution for their clients.
We have selling agreements with more than 200 of the
top national, regional, independent broker/dealers and registered
investment advisor-based platforms. Currently, more than 500
financial intermediaries are using the Arrow DWA Balanced
Fund. We are focused on getting financial intermediaries to fol-
low the endowment path of adding “absolute return” assets to
their clients’ portfolios. We know that many of them are using
hedge funds and managed futures strategies for their high net
worth clients. The innovation of blending three alternative strate-
gies within a low-cost mutual fund wrapper allows many of our
clients to finally offer an “absolute return” strategy to investors
who normally don’t have access to this type of strategy.
TWST: Is there anything that you would like to add?
Mr. Flaig: Many of our clients ask us how much they
should move toward alternative strategies. We typically tell our
clients that the investor’s risk profile should dictate that. How-
ever, the risk band of some alternative strategies makes it difficult
to pin down a realistic allocation. Then we point the client toward
the endowment path. Most endowments have already identified
their allocations, which is critical for positioning their school as-
sets and budgets. Their portfolios need to participate in strong
upside markets while limiting their exposure to the downside. If
they fail, the school assets drop and their operating budget is re-
duced, resulting either in a possible increase in tuition or the need
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
Correlation of Alternative Asset
An investor should consider the Fund's investment objective, risks, charges, and expenses carefully before investing or sending
money. This and other information about Arrow Funds is contained in the fund's prospectus, which can be obtained by calling
1-877-277-6933. Please read the prospectus carefully before investing. Arrow Funds is distributed by Aquarius Fund Distributors.
1161-AFD-11/20/2007
The Arrow Alternative Solutions Fund may not be suitable for all investors. The fund’s use of derivatives such as futures, options
and swap agreements may expose the fund to additional risks that it would not be subject to if it invested directly in the securities
underlying those derivatives. Investing in leveraged instruments will magnify any gains or losses on those instruments. Investing in
commodity and currency related securities may be subject to greater volatility than investments in traditional securities. The fund's
use of short selling involves increased risks and additional costs. Investing in small-cap securities, may have special risks associated
including wider variations in earnings and business prospects than larger, more established companies. The Fund may invest in fixed
income securities, which are subject to risks including interest rate, credit and inflation. The maximum sales charge for Arrow’s
A-shares is 5.75%. A-share investors may be eligible for a reduction in sales charges. The Fund charges a fee of 1.00% on redemptions
of shares held less than 30 days. The Arrow DWA Balanced Fund’s annual operating expense is 2.01%. The Arrow Alternative
Solutions Fund’s annual operating expense is 1.52%.
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
to spend a portion of the endowment base during down markets.
Many advisors need to look at their clients’ portfolios in the same
light. There are 62 endowments funds that manage assets of more
than $1 billion. Collectively, these endowments manage more
than $229 billion and allocate 22.4% of their portfolios toward
absolute strategies. Since 2002, that allocation has increased 26%
during a very strong equity market.
Many of our clients also ask us what component of the
portfolio should be reduced. Most optimizers will reduce the
riskier assets like equities. My advice would be to follow what the
smart money is doing. The 62 endowments that we mentioned
earlier have reduced their fixed income exposure by 39% since
2002. It makes sense. During the last three-year bear market
(April 2000 to March 2003), the S&P 500 was down 16.1% a
year while bonds were up 9.8%. Our alternative strategy, which
we will use as a proxy for absolute returns, was up 12.9%. Since
1999, the strongest three-year period for the S&P 500 was from
April 2003 to March 2006. During that period, the S&P 500 was
up 17.2% a year but bonds were only up 2.9%. Absolute return
strategies are designed to respond in all market conditions. While
bonds provided the support during down markets, it typically does
not participate equally when the markets are strong. Our alterna-
tive strategy over the same bull market period was up 12.7% a
year. That is why endowments have reduced their fixed income
exposure and maintained the same equity exposure since 2002.
Absolute return strategies are typically not correlated to
the movement of traditional assets. The beauty of the Arrow Al-
ternative Solutions Fund is that it combines strategies that do not
exhibit a high correlation to one another, potentially giving the
investor an opportunity to reduce risk without sacrificing returns.
We believe that in order to realize the benefit of diversification, a
portfolio’s underlying asset classes must behave differently in
varying market conditions. If the investor’s goal is to secure
higher returns at a lower risk, integrating alternatives into a tra-
ditional portfolio should help reduce portfolio volatility and im-
prove the odds of preserving capital over the long term. This is
the value proposition of the Arrow Alternative Solutions Fund.
TWST: Thank you.
Note: Opinions and recommendations are as of November 1, 2007.
M O N E Y M A N A G E R I N T E R V I E W ——————— A b s O l u T E R E T u R N s T R A T E G I E s
© 2007 The Wall Street Transcript, 48 West 37th Street, NYC 10018Tel: (212) 952-7400 • Fax: (212) 668-9842 • Website: www.twst.com
Definitions
Volatility is a measure of fluctuations in value based on annualized standard deviation of monthly returns. Beta is a measure of
relative risk. Correlation is similarity in performance to the equity markets. Sharpe Ratio measures risk-adjusted returns by taking the
return less the risk-free rate, and dividing the result by the standard deviation. Absolute returns are generally positive rerturns in any
market environment.
Footnotes
The Arrow Alternative Strategy reflects hypothetical or simulated performance figures and is not meant to represent actual performance
results for the Arrow Alternative Solutions Fund. Past performance is not indicative of future results. Potential for profit is accompanied
by possibility of loss. These figures reflect a simulated portfolio managed with the Arrow Alternative Strategy using actual &
hypothetical performance data for various financial instruments based on Arrow Investment Advisors analysis. The simulated model was
constructed using their proprietary set of rules for the purchase and sale of securities for each underling strategy as outlined in the Arrow
Alternative Solutions Fund prospectus. There can be no assurance that actual transactions would have given the same results, although
the manager believes results of actual trades would have been very similar. Performance results reflect the re-investment of dividends
and other earnings. The performance results are net transaction costs and operating expenses associated with the management of the
Arrow Alternative Strategy. The performance of the Hypothetical Arrow Alternative Strategy was reduced by 252 bps annually.
Performance displayed represents past performance, which is no guarantee of future results. The information provided here is
for informational purposes only, is not intended as investment advice and should not be construed as a recommendation with regard to
investment decisions. Source for charts and graphs: Morningstar, Bloomberg, Deutsche Bank calculated by Arrow Investment Advisor,
LLC. The index returns assumes re-investment of all dividends but do not reflect any management fees, transaction costs or expenses.
The indices are unmanaged and are not available for direct investment. The Strategy benchmark comparison returns are comprised
of three Credit Suisse / Tremont hedge Fund Indices: 33.3% Long Short equity, 33.3% Fixed Income Arbitrage and 33.3% Managed
Futures indices. The Credit Suisse/ Tremont hedge Fund Indices are the asset-weighted benchmarks of hedge fund performance.
It is not possible to invest in indexes which are unmanaged and do not incur fees and charges. The 60% equities and 40% bonds is
comprised of S&P 500 and Lehman Aggregate Bond Index. The S&P Index is the Standard & Poor’s Composite Index of 500 stocks
and is a widely recognized, unmanaged index of common stock prices. The Lehman Brothers U.S. Aggregate Bond Index is an
unmanaged index composed of investment-grade securities from the Lehman Brothers Government/Credit Bond Index, Mortgage-
Backed Securities Index, and Asset-Backed Securities Index.