1

Hedge Funds:

Issues for Institutional Investors

Robert A. Jaeger, Ph.DVice Chairman and Chief Investment Officer

September 2005

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Motives for Investing

Potential for

Attractive absolute return

LIBOR plus 3% to 8%, depending on risk tolerance

Volatility lower than standard equity benchmarks

Low correlation with standard markets, especially in down markets

Above points apply to a diversified portfolio of hedge funds. Individual funds are substantially more risky.

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Issues

Return/risk profile

Historical

Expected

Sources of return and risk

Leverage and short selling

Performance fees

Transparency

Is there a hedge fund bubble?

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A Cautionary Note on Historical Data Many databases suffer from biases that may skew the

returns upward. Survivor bias “Bad news travels slow”

Many indexes show historical records that precede the construction of the index: these are purely hypothetical results.

EACM100® Index* Public record since January 1996 100 managers covering all main strategies and sub-

strategies Qualitative manager screening

*EACM100® Index – Onshore Funds was launched January 1, 1996.

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Major Hedge Fund CategoriesM

ore

Ris

k

L

ess

Ris

k Relative value: long vs. short positions, minimal net market exposure.

Event-driven: net long bias, emphasizing specific corporate transactions (mergers, acquisitions, reorganizations, etc.) likely to produce definable changes in value within a definable period (typically 3-12 months).

Equity hedge funds: “micro” investors focused on stock selection and company analysis, enhanced with ability to use leverage and sell short.

Global asset allocators: “macro” investors who can be long, short or neutral with respect to multiple markets (interest rates, currencies, equity indexes, commodities).

Short sellers: net short, usually focused on US equities, designed as hedge against down markets.

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Deal Arbitrage

Distressed Debt

ED/Multi-Strategy

Domestic Long Biased

Domestic Opportunistic

DiscretionarySystematic US Equity

US Bonds

International Bonds International Equity

T-Bills

RV/Multi-Strategy

Bond Hedge

Mkt Neutral Equity

Global/International

Convertible Hedge

0

2

4

6

8

10

12

14

16

0 5 10 15 20 25

Annualized Standard Deviation (%)

Ann

uali

zed

Rat

e of

Ret

urn

(%)

Historical Risk/Return Characteristics

January 1996 – July 2005

Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1996 – December 2003) and EACM100® Offshore Funds (January 2004 – July 2005) See www.eacm.com for more information regarding the EACM100® Index.

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Conv Hedge

Global/International

Mkt Neut Eq

Bond Hedge

RV/Multi-Strategy

T-Bills

InternationalEquity

Inter'lBondsUS Bonds

US Equity

Short Selling

Systematic

Discretionary

Dom Oppo

Domestic Long Biased

ED/Multi-Strat Distressed

Deal Arbitrage

-4

-3

-2

-1

0

1

2

3

4

5

6

0102030405060708090100

Gain Frequency (%)

Ave

rage

Ret

urn

(%)

Performance in S&P 500 Negative Months

US Equity (S&P 500 Composite) was down 38% of the months, with an average monthly loss of 3.9%.

Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1996 – December 2003) and EACM100® Offshore Funds (January 2004 – July 2005) See www.eacm.com for more information regarding the EACM100® Index.

January 1996 – July 2005

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Two Kinds of Strategies

Many hedge fund strategies employ “enhanced active management”: traditional active management enhanced with short selling, leverage, and other techniques. For example:

Market neutral equity Fixed income arbitrage Equity hedge funds Global macro investing

Some hedge fund strategies are genuinely distinctive, not based on traditional techniques. These strategies are important sources of liquidity for financial markets.

Convertible hedging Risk arbitrage Distressed debt

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How Do Hedge Funds Make Money?

Hedge funds make money the old-fashioned way: they take risk.

Beware of common stories that underestimate risk:

“They exploit market inefficiencies” – not enough to go around

“They supply liquidity to markets” – some do, some don’t

“They take advantage of manager skill” – there are many skilled managers in the long-only universe, and many hedge fund managers who are not as skilled as they think.

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Do Hedge Funds Make Money?

Our working assumption is that hedge funds, in aggregate, do not make money. Manager selection and strategy

allocation are critical Hedge funds are like venture capital:

the object of the game is not to earn “the average return”

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Risk Factors

General risks Leverage Concentration Illiquidity

Market-related risks Directional market risk Non-directional systematic risks (“alternative betas”),

e.g., Equity: long value vs. short growth, long small cap vs.

short large cap Fixed income: carry trades: long higher risk vs. short

lower risk Exposure to volatility and “trendiness”

Organizational risks Small shops, smaller asset bases, shorter records Blow-up risk, headline risk

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Leverage and Short Selling

Short selling is sometimes designed to reduce risk, sometimes designed to enhance return, sometimes both.

Leverage definitely increases risk, may or may not increase return.

Levels of leverage vary by strategy. For most strategies, maximum leverage (gross exposure/net capital) is 2:1. Main exceptions: convertible hedging, fixed income arbitrage, global asset allocators. Note: leverage has to be adjusted for volatility of positions.

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Performance Fees

Most hedge funds charge a combination of asset-based and performance-based fees, often 1% plus 20%, or more.

Performance fees grant the hedge fund manager a “free call option” on the fund’s performance, may create an incentive to take incremental risk.

Most hedge fund managers are long-term greedy, not short-term.

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Hedge funds generally offer much less transparency than traditional separately managed accounts.

Many institutional investors are overly obsessed with transparency, failing to distinguish between

Daily position and transaction reports

and

Useful portfolio information

Even 100% transparency does not guarantee protection from problems. Staying out of trouble is much more important than getting out of trouble.

Transparency

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The Current Environment

Dramatic growth 8,000-10,000 hedge funds 1,000 funds of funds $1 trillion in assets

Growth driven by: Demand: the search for absolute return Supply: the search for more money and

more freedom Recent returns below some people’s

expectations Are hedge funds destroying their own

opportunities?

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The Brain Drain

The world does not need 10,000 hedge funds. The number of funds has grown dramatically; the number of worthwhile funds has not

The “brain drain”: starting a fund is easy, succeeding is not. This applies even to “celebrity managers”

Beware of the “life cycle” myth: newer is better than older

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The Currently Fashionable Cynicism Recent returns have been poor.

There are too many funds.

Recent returns have been poor because there are too many funds.

Our view: Returns have been in line with reasonable

expectations. There are too many funds Some strategies face “crowding issue,” others

do not.

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Performance by Strategy

Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Offshore Funds (January 2004 – July 2005) See www.eacm.com for more information regarding the EACM100® Index. Source: EACM Advisors LLC and Standard &Poor’s 500

EACM 100® Index – Offshore Funds 4.7 2.4 Allocation %

Relative Value 30 2.3 2.2Market Neutral Equity 10 -0.2 5.1Convertible Hedge 6 0.6 -3.1Bond Hedge 7 5.1 3.6Multi-Strategy 7 4.4 1.3

Event-Driven 15 11.3 4.1Deal Arbitrage 5 4.4 3.1Bankruptcy/Distressed 5 13.8 4.4Multi-Strategy 5 15.5 4.9

Equity Hedge Funds 30 7.1 3.8Domestic Long Biased 10 6.6 2.9Domestic Opportunistic 10 5.4 4.9Global/International 10 8.7 3.6

Global Asset Allocators 20 4.1 0.3Discretionary 10 5.8 0.5Systematic 10 2.3 0.6

Short Selling 5 -10.9 -1.4

S&P 500 Composite 10.9 2.9

2004 Annual Return %4.7

2.3-0.2

0.65.1

4.4

11.34.4

13.815.5

7.16.6

5.48.7

4.15.8

2.3

-10.9

10.9

-15 -10 -5 0 5 10 15 20

2005:Jan - July Return %2.4

2.25.1

-3.13.6

1.3

4.13.1

4.44.9

3.82.9

4.93.6

0.30.50.6

-1.4

2.9

-15 -10 -5 0 5 10 15 20

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Is there too much money chasing too few opportunities? Important to separate homogeneous strategies from heterogeneous strategies.

Homogeneous: Managers tend to “herd” around similar positions, e.g., convertible hedging, risk arbitrage, distressed debt.

Heterogeneous: Wide divergence among manager positions, e.g. equity hedge funds, global asset allocators. Beware of glib generalizations about “what hedge funds are doing.”

Homogeneous strategies are more vulnerable to “crowded trade” problem.

If hedge funds were in business to exploit market inefficiencies, then growth would be a major problem. But: inefficiencies are not the drivers of return.

Are Hedge Funds Destroying Themselves?

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The Real Problems: Low Volatility and Low Dispersion

Historical Volatility

Implied Volatility Dispersion

OEX Historical Index and Stock Volatility, Implied Index and Stock Volatility, and Cross-Sectional VolatilitySource: Citigroup Smith Barney and the Chicago Board of Options Exchange

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Did Hedge Funds Cause these Problems?

No – they would do this only if hedge funds, in aggregate, pursue contrarian trading strategies that act as a negative feedback loop in the markets. In fact, many hedge funds are more momentum-oriented, acting as a positive feedback loop.

Several years ago, hedge funds were blamed for adding to market volatility. You can’t have it both ways.

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Which market has the highest return volatility?

100

105

110

115

120

125

1 3 5 7 9 11 13 15 17 19 21

100

105

110

115

120

125

1 3 5 7 9 11 13 15 17 19 21

100

105

110

115

120

125

1 3 5 7 9 11 13 15 17 19 21

100

105

110

115

120

125

1 3 5 7 9 11 13 15 17 19 21

Panel A Panel B

Panel C Panel D

Hint: Standard deviation is not sensitive to the order of returns.Each panel represents the same number of observations, with the same starting and ending point of 100. The cumulative rate of return is 0.0%.

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Conclusion

Hedge funds do offer the potential for an attractive return/risk profile.

The current environment does present some special challenges.

Investors need realistic expectations, steering a course between the exaggerations of the marketers and the exaggerations of the cynics.