1

Hedge Funds:

Inside the Buyer’s Head

Robert A. Jaeger, Ph.D.March 21, 2005

2

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

3

Issues

Sources of return and risk

Leverage, short selling, and taxation

Performance fees

Transparency

Capacity: is there a hedge fund bubble?

4

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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Convertible Hedge

Global/International

Mkt Neutral Equity

Bond Hedge

RV/Multi-Strategy

T-Bills International Equity

International Bonds

US Bonds

US Equity

Short Selling

SystematicDiscretionary

Domestic Opportunistic

Domestic Long Biased

ED/Multi-Strategy

Distressed Debt

Deal Arbitrage

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

1995 – 2004:October

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 1990 – December 2003) and EACM100® Index – Offshore Funds (January 2004 – October 2004.) 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

1995 – 2004:October

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 1990 – December 2003) and EACM100® Index – Offshore Funds (January 2004 – October 2004.) See www.eacm.com for more information regarding the EACM100® Index.

US Equity (S&P 500 Composite) was down 38% of the months, with an average monthly loss of 4.0%.

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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” – hedge funds have no monopoly on manager skill

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Risk Factors

General risks Leverage Concentration Illiquidity

Market-related risks Directional market risk Non-directional systematic risks, 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, Short Selling, and Taxation

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.

Leverage can create Unrelated Business Taxable Income (UBTI) for tax-exempt investors. The use of offshore funds generally avoids UBTI.

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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.

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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

Transparency

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Some common estimates:

7,000 – 10,000 hedge funds

1,000 fund of funds

Total assets $800 billion - $1 trillion

Steady growth in recent years, driven by weaknesses in traditional markets, concerns about rising interest rates

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.

Capacity issues are more pronounced in homogeneous strategies.

Capacity and Bubbles

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2004 Performance

2004 Annual Return

EACM 100® Index 4.7%

MSCI Hedge Fund Composite 6.6%

CSFB/Tremont Investable Index 5.2%

S&P Hedge Fund Index 3.9%

HFRI Fund of Funds Composite Index 6.4%

CISDM Hedge Fund Index – Fund of Funds (Median) 9.2%

Most funds of funds target a net return of LIBOR plus 3%-8%. Returns in 2004 were at the low end of the range.

Some returns are based on preliminary results and subject to change.

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Performance by Strategy

EACM 100® Index – Offshore Funds

Relative ValueMarket Neutral EquityConvertible HedgeBond HedgeMulti-Strategy

Event-DrivenDeal ArbitrageBankruptcy/DistressedMulti-Strategy

Equity Hedge FundsDomestic Long BiasedDomestic OpportunisticGlobal/International

Global Asset AllocatorsDiscretionarySystematic

Short Selling

S&P 500 Composite

4.7

2.3-0.2

0.65.2

4.4

11.24.4

13.715.3

6.96.5

5.38.9

4.15.8

2.2

-10.8

10.9

-15 -10 -5 0 5 10 15 20

2004 Annual Return %

Source: EACM Advisors LLC

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Low Volatility Equity market volatility has been very low, both at the

index level and the individual stock level. This applies both to implied and realized volatility.

Low volatility is particularly hard on convertible hedging, but also hurts other strategies that depend on price movements for trading profits.

Source: Citigroup/Smith Barney and Chicago Board Options Exchange

Implied Index and Stock Volatility

Historical Index and Stock Volatility

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Low Dispersion of Returns

Hedge funds need stocks to display differences in return, but dispersion is at historically low levels.

Source: Citigroup/Smith Barney and Chicago Board Options Exchange

Historical Cross-Sectional Stock Volatility

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Did Hedge Funds Cause these Problems?

Hedge funds are clearly not the cause of low short term interest rates.

Do hedge funds cause low volatility and low dispersion? 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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Heterogeneous Strategies

Many hedge fund strategies are extremely heterogeneous, especially: Equity hedge funds Global asset allocators

Diversity holds at two levels: Setting up the position Managing gains and losses

Most hedge funds tend to cut losses quickly Some hedge fund managers like to add to winning

positions, others are quicker to take profits.

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Heterogeneity in Action

Short Position

Builder

Trimmer

Long Position

Builder

Trimmer

Buy

Sell

Sell

Sell

Buy

Buy

Sell

Buy

Stock downStock up

Beware of glib generalizations about “what the hedge funds are doing.”

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Two Final Thoughts

Many people think that hedge funds make money by identifying inefficiencies and anomalies. On this view, the growth of the business means that the inefficiencies will get “arbed away.” But most hedge funds do not make money by seeking inefficiencies.

Be careful about database returns and index returns. Our basic suspicion is that hedge funds, in aggregate, do not make money. Manager selection and strategy diversification are the keys to success. Hedge fund investing is like venture capital investing: the performance of the median fund is not compelling, but a well-managed portfolio can provide excellent risk/return properties.