The opinions expressed in this presentation are those of the speaker. The International Foundationdisclaims responsibility for views expressed and statements made by the program speakers.
The Pros and Cons of Hedge Funds
Sharon M. GoodmanPrincipalSlevin & Hart, P.C.Washington, D.C.
Michael D. Joyce, Esq., CEBSExecutive Vice President and Senior ConsultantThe Marco Consulting GroupBoston, Massachusetts
Edward D. Patchett, CFADirector, Business DevelopmentGCM GrosvenorChicago, Illinois
I09-1
Hedge Funds–Three Perspectives
• Reintroduction to hedge funds and fund of funds strategies—Why do investors use hedge funds—An investment consultant’s perspective
• Hedge fund risks, returns and expectations—An investment manager’s perspective
• Ways to protect your plan—A plan counsel’s perspective
• After recent performance struggles, what does the future hold for hedge fund strategies and investors’ sentiment?
I09-2
What Are Hedge Funds?
• Privately-offered investment vehicles not constrained by a specific benchmark
• Use traditional and alternative asset classes
• Use specialized trading strategies—More tools available
• Attempt to take advantage of market inefficiencies
• Use an expanded set of financial instruments and securities
• Can use leverage• Generally have less exposure to market
risk
I09-3
Hedge Fund Strategies
4
RELATIVE VALUE
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral
EVENT DRIVEN
Merger ArbitrageSpecial Situations
Distressed Securities
DIRECTIONAL
Global MacroLong BiasedShort Sellers
Target Return %
LOWER
HIGHER
Expected Risk %LOWER HIGHER
I09-4
Why Plans Initially Got Involved
Diversification / Low Correlation
• HFOFs and hedge funds generally offer differentiated risk/return profiles relative to traditional bond and equity investments
• HFOFs and hedge fund strategies offer a variety of correlation benefits
Preservation of Capital / Downside Protection
• HFOFs and hedge funds have consistently preserved capital during more stressed market environments
Reduced Equity Volatility
• HFOFs and hedge funds use a variety of investment tools to mitigate equity risk in order to deliver steady returns with lower volatility
• Long-term, HFOFs and hedge funds have outperformed unhedged investments on a risk-adjusted basis
Diversification / Investment Flexibility
• HFOFs and hedge funds offer flexible investment mandates, enabling them to adapt to changing market environments and to capitalize on the prevailing opportunity set
I09-5
Why Plans Initially Got InvolvedDiversification / Correlation Benefits
Correlation Analysis: January 1994 - April 2016
HFRI FOF Composite S&P 500 S&P 400 Index
(Mid Cap)S&P 600 Index
(Small Cap) MSCI ACWI Barclays U.S Aggregate Bond
Barclays HY Credit
Bloomberg Commodity Index
S&P 500 0.607
S&P 400 Index (Mid Cap) 0.656 0.900
S&P 600 Index (Small Cap) 0.621 0.792 0.914
MSCI ACWI 0.684 0.944 0.881 0.789
Barclays U.S Aggregate Bond 0.038 0.035 0.007 -0.072 0.019
Barclays HY Credit 0.546 0.625 0.649 0.613 0.678 0.217
Bloomberg Commodity Index 0.445 0.317 0.374 0.328 0.428 0.045 0.359
CS Leveraged Loan Index 0.474 0.428 0.481 0.444 0.488 -0.022 0.756 0.368
I09-6
‐0.79%
1.70%
0.82%
‐3.51%
3.24%
0.84%
Down Market Up Market All Markets114 months 206 months 320 months
Why Plans Initially Got InvolvedDownside Protection
Up/Down Market Analysis
HFRI FW Composite
S&P 500 Index
Data sources: Hedge Fund Research (HFR); S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.
Average monthly net returnsJanuary 1990 – August 2016
I09-7
3 4
16
27
47
66
75
49
25
8
38
11
16
30
19
35
44
33
28
66
< ‐4% ‐4% to‐3%
‐3% to‐2%
‐2% to‐1%
‐1% to0%
0% to1%
1% to2%
2% to3%
3% to4%
> 4%
Extreme negative
Strongnegative
Modest negative
Modest positive
Strong positive
Extreme positive
38 instances of “extremenegative” monthly returns for equities; 3 instances for hedge funds
HFRI FW Composite
S&P 500
Count of monthly returns by rangeJanuary 1990 – August 2016
Why Plans Initially Got InvolvedPositive Slope to
Hedge Fund Returns
Data sources: Hedge Fund Research (HFR); S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.
I09-8
Why Plans Initially Got InvolvedDownside Protection
Hedge Funds During Challenging Environments
‐2.8%
‐0.1%
‐1.3%
‐6.1%
‐3.5%
‐2.2%
‐1.2%
‐1.5%
‐8.7%
‐6.8%
‐8.1%
‐8.4%
‐8.4%
‐8.9%
‐9.0%
‐9.1%
‐10.6%
‐10.9%
‐14.5%
‐16.8%
Sep‐01
Jan‐09
Jun‐08
Sep‐08
Aug‐90
Feb‐01
Feb‐09
Sep‐02
Aug‐98
Oct‐08
Ten worst monthly S&P 500 drawdownsJanuary 1990 – August 2016
Data sources: Hedge Fund Research (HFR); S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.
HFRI FW Composite
S&P 500 Index
I09-9
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
Jan‐90
Jan‐91
Jan‐92
Jan‐93
Jan‐94
Jan‐95
Jan‐96
Jan‐97
Jan‐98
Jan‐99
Jan‐00
Jan‐01
Jan‐02
Jan‐03
Jan‐04
Jan‐05
Jan‐06
Jan‐07
Jan‐08
Jan‐09
Jan‐10
Jan‐11
Jan‐12
Jan‐13
Jan‐14
Jan‐15
Jan‐16
$12,705.73, HFRI Fund Weighted Composite Index
$10,858.11, S&P 500 Index
$5,131.43, Barclays U.S. Aggregate Bond Index
Why Plans Initially Got InvolvedHigher Cumulative Return, Lower Volatility
Annualized Return VolatilityHFRI FW Composite 10.0% 6.7%
S&P 500 9.4% 14.5%
Barclays U.S. Agg. 6.3% 3.6%
Data sources: Hedge Fund Research (HFR); Barclays Bank PLC, 2016; S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.
Growth of $1,000 vs. market indicesJanuary 1990 – August 2016
I09-10
Why Plans Initially Got InvolvedImprove Risk Adjusted Performance
60%
40%
60/40 Portfolio
Asset Allocation: Time Period 01/1990 to 01/201660/40
Portfolio 5% to Hedge
Funds10% to Hedge
Funds15% to Hedge
Funds
Annualized Return 8.22% 8.16% 8.10% 8.04%
Annualized Standard Deviation 9.04% 8.75% 8.45% 8.17%
Sharpe Ratio 0.88 0.90 0.93 0.95
57%38%
5%
5% Allocation to Hedge Funds
54%36%
10%
10% Allocation to Hedge Funds
51%34%
15%
15% Allocation to Hedge Funds
Improve plan level risk adjusted performance
I09-11
Why Plans Initially Got InvolvedSummary Check List
Diversification / Correlation Benefits
Preservation of Capital / Downside Protection
Reduced Equity Volatility
Investment Flexibility
I09-12
Considerations When ERISA Plans Invest In Hedge Funds
• Plan Document Considerations• Who is the Fiduciary For Investment—
Manager or Trustees?• Due Diligence• Potential Contracting Pitfalls And Solutions
For Benefit Plan Investors
I09-13
Plan Document Considerations
• Do Your Plan Governing Documents Allow for this Hedge Fund Investment?– Trust Agreement– Investment Policy
• Avoid unnecessary ERISA fiduciary breach issue (ERISA Section 404(a) failure to follow plan documents)
I09-14
Who is Fiduciary For Investment?
• Who is ERISA fiduciary for investment—Trustees or Manager?
• Does Investment Hold Any ERISA Plan Assets?• If NO, Trustees remain fiduciary for investment.• If YES, Not Treated As ERISA Plan Assets if Participation
By ERISA Benefit Plan Investors Less Than 25% of Investors.– 25% Excludes Governmental, Certain Church and Foreign Plans.
• If ERISA Plan Assets over 25%, Manager is fiduciary (unless exception applies).
I09-15
Exceptions To Who is Fiduciary For Investment
• Not Plan Assets Subject to ERISA if investment in Venture Capital Operating Company (VCOC Rules)—Usually private equity strategy.
• VCOC is entity with at least 50% of its assets invested in “venture capital investments” in which it has “management rights”.
• Management rights = Rights to substantially influence management of the operating company.– Must be “direct” rights that VCOC can exercise.
• Asset/management tests done annually.
I09-16
Exceptions To Who is Fiduciary For Investment
• Not Plan Assets Subject to ERISA if investment in Real Estate Operating Company (REOC Rules).
• REOC is entity with 50% or more of its assets invested in qualifying real estate and directly engaged in real estate management or development activities.
• Tested with first investment and annually thereafter.
I09-17
Hedge Fund of Fund Special Delegation Issues
• Named Fiduciary = Only fiduciary with ability to delegate its ERISA fiduciary duty to another entity
• Must be identified in Plan Document (Trust Agreement)• Board of Trustees/Retirement Committee usually named fiduciary • “Master manager” of hedge fund of funds
– Is master manager also a named fiduciary to delegate ERISA fiduciary duty to sub-managers/underlying investment funds?
– Does Trust Agreement allow designation of master manager as named fiduciary?
– If not, does master manager acknowledge that it is liable for sub-manager’s actions?
I09-18
Due Diligence Before Investing In Hedge Fund
Investment Consultant Role• Selection And Ongoing Monitoring• Asset Allocation Decision• Modeling And Stress Testing
– Look-Through Analysis Of True Risk Exposures– Return expectation and timing/ “J curve”– Lock-ups and cash flows
• Independent Valuation• DOCUMENT PROCESS!
I09-19
Issues Under Investment Contract
• Side Letter To Hedge Fund Investment - Documents– Governs if investment fund documents inconsistent– Right to see side letters of other investors
• Standard of Care– ERISA fiduciary standard– ERISA-like contractual standard– ERISA-light contractual standard (prudence standard only)
• Indemnification– By manager of Plan and Trustees?– By investment fund of manager?– By Trustees personally?
I09-20
Issues Under Investment Contract
Fees• Most Favored Nations (“MFN”) Treatment on Fees, Rights
and Features• Fees on Un-called Capital• Incentive Fees
– Warrant under DOL guidance? – Valuation of Portfolio and Potential Conflicts
• Claw back– How is high-water mark for payment of incentive fees set and
reset?
I09-21
Issues Under Investment Contract
More Fees• Unrelated Business Taxable Income
– Effort to avoid?– Protections if taxable income is earned?– Impact of tax on net return/incentive fee?
• Imposition of Organizational and Operating Expenses – Charged to investor or manager absorbs?– Capped?– If early investor, spread to later investors?
I09-22
Issues Under Investment Contract
• Confidentiality– Of Plan’s information?– Of Plan’s identity?
• Reporting– Sufficient for ongoing monitoring by investment
consultant? – Financial statements of underlying investments? – Section 101(k) for multiemployer plans?
I09-23
Issues Under Investment Contract
• Conflicts of Interest– Avoided, either by ERISA or by contract?
– Limits on hiring its affiliates for middle & back-office services?
– Fees from underlying investments/investment managers?
– Valuation by independent entity
• Scope of other agent’s liability (administrator, custodian, board of directors)
I09-24
Issues Under Investment Contract
• Voting– Pro-rata? – Control over changes in future?
• Investor Advisory Councils– Right to position (if desired)
• Involuntary Redemptions– Allowed?– At any time?– For limited reasons or manager’s complete discretion?
I09-25
Issues Under Investment Contract
• How To Get Out? – No Fault Divorce/Liquidity—When and with What
Notice?– Lock Up?– Liquidation impractical or inadvisable?– Extended beyond initial term? If so, who decides? – Unilateral by manager as GP or vote of investors?– What is Fund getting—in kind or cash? – If in kind, who manages until liquidated and for what
fee?
I09-26
Hedge Funds as Return Enhancers or Help Reduce Volatility?
Limited Recent Outperformance (Alpha) Compared to Public Markets
Annualized net returns by calendar year
Rolling period returns and volatility
2010 2011 2012 2013 2014 2015 YTD 2016
HFRI FW Composite 10.3% ‐5.3% 6.4% 9.1% 3.0% ‐1.1% 3.5%
S&P 500 15.1% 2.1% 16.0% 32.4% 13.7% 1.4% 7.8%
Barclays U.S. Agg. 6.6% 7.8% 4.2% ‐2.0% 6.0% 0.6% 5.9%
Trailing 1‐year Trailing 3‐years Trailing 5‐years
Ann. return Volatility Ann. Return Volatility Ann. Return Volatility
HFRI FW Composite 2.8% 4.6% 3.6% 4.0% 3.5% 4.6%
S&P 500 12.6% 12.4% 12.3% 10.7% 14.7% 11.6%
Barclays U.S. Agg. 6.0% 2.2% 4.4% 2.6% 3.2% 2.6%
Data sources: Hedge Fund Research (HFR); Barclays Bank PLC, 2016; S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.
I09-27
Hedge Fund PerformanceV-Shaped MarketsOver The Last Year
1800
1900
2000
2100
2200
Jul‐15 Oct‐15 Jan‐16 Apr‐16
+13.0%
‐13.3%+15.9%
‐6.4%
‐12.2%
S&P 500 Index Level
Significant up and down fluctuations in equity marketsJuly 2015 – June 2016
Data sources: S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.
I09-28
Hedge Funds PerformanceSaturation – Impact on Market Efficiency
$-
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000
AU
M ($ bil)
Num
ber o
f Hed
ge F
unds
Growth of Hedge Fund & ETFsOver Time
Number of Hedge Funds Hedge Fund AUM ($ bil) ETF AUM ($ bil)
Select Reasons for ETF Proliferation Simplicity
Enhanced Liquidity
Speed of Execution
Diversification
Attractive fees
Source: Eurekahedge, Preqin, http://www.statista.com/statistics/224579/worldwide‐etf‐assets‐under‐management‐since‐1997/, Global Trends in Institutional ETF Adoption: Drivers from Growth Through 2020 (Greenwich Associates)
Select Risks of ETF Proliferation
Market instability
Market efficiency
Herd mentality
I09-29
Hedge Funds PerformanceEfficient Markets Impact Performance
8%
87%77%
51%
80%91%
74%
44%
-92%
-13%-23%
-49%
-20%-9%
-26%
-56%
-100%
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
2008 2009 2010 2011 2012 2013 2014 2015
S&P 500 Dispersion CY 2008 - CY 2015
I09-30
Hedge Funds PerformanceOver-Diversification? Similar Fund
Characteristics?
1
3 ‐ 6
25 ‐ 50
8,000+Underlying Security
Investments(Long & Short)
Underlying Hedge Fund Investments
Month Liquidity Provisions (On Average)
Traditional Multi‐Strategy HFOF Vehicle
Source: Lighthouse Partners, K2 Advisors
I09-31
Investors’ intentions for their hedge fund allocations in next 12 months
20%10% 9%
20%8%
16%
32%
51%
54% 53%
47%60%
58%
44%
29%35% 38% 33% 32%
26% 25%
0%
20%
40%
60%
80%
100%
Dec‐09 Dec‐10 Dec‐11 Dec‐12 Dec‐13 Dec‐14 Dec‐15
Prop
ortio
n of Investors
Source: Preqin Hedge Fund Investor Interviews
Increase allocation
Maintain allocation
Decrease allocation
Commitment to HedgeFunds Today
How Investors View Hedge Funds
Source: The 2016 Preqin Global Hedge Fund Report.
I09-32
Commitment to HedgeFunds Today
How the Investment Consultant Community Views Hedge Funds
Despite recent performance struggles, institutions and consultants alike remain steadfast in their pursuit of hedge fund‐like exposures as critical
components of broader portfolios.
40%25%
45%58%
15% 17%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2014 2015
Investment Consultant Recommendations for HF Allocations, 2014 vs. 2015
Recommended ClientsInvest Less Capital inHFs than in PreviousYear
Recommended ClientsInvest the Same Amountof Capital in HFs as inPrevious Year
Recommended ClientsInvest More Capital inHFs than in PreviousYear
12%
24%
32%
20%
8%
4%
0%
5%
10%
15%
20%
25%
30%
35%
Recommended Portfolio Allocation to HFs (as % of AUM)
Source: 2016 Preqin Global Hedge Fund Report
I09-33
0
1,500
3,000
4,500
6,000
7,500
9,000
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2Q 201
6
Estimated Hedge Fund Assets ($ billions) Estimated Number of Hedge Funds
As of June 30, 2016:
AUM: $2,898 billion
Count: 8,406 hedge funds
Despite Recent Performance, Hedge Fund
Industry Is StableAUM (left) and number of funds (right)January 1990 – June 2016
Source: HFR Global Hedge Fund Industry Report – Second Quarter 2016 © HFR, Inc. 2016, www.hedgefundresearch.com.
I09-34
Evolving Hedge Fund Investment Landscape
Improved partnership between managers and investors• Customization • Transparency• Fees
Portfolio concentration• New strategies blur the lines of PE vs. HF vs. traditional investing
Regulatory changes• Increase in talent leaving banks to join hedge funds• Hedge funds replacing banks as longer-term liquidity providersHedge Fund Alternatives
I09-35
Potential for widening credit spreads and increasing defaultsHigh yield spreads near pre‐crisis levels
Potential for rising bond yields and falling bond pricesGovernment bond yields continue to compress
Equity m
arkets
Potential Headwinds for Traditional Assets?
0 bp
500 bp
1000 bp
1500 bp
2000 bp
Jan‐00 Jan‐02 Jan‐04 Jan‐06 Jan‐08 Jan‐10 Jan‐12 Jan‐14 Jan‐16
‐5%
0%
5%
10%
15%
20%
25%
Jul‐11 Jul‐12 Jul‐13 Jul‐14 Jul‐15 Jul‐1612
13
14
15
16
17
18
19
20
Jul‐11 Jul‐12 Jul‐13 Jul‐14 Jul‐15 Jul‐16
0%
1%
2%
3%
4%
5%
6%
7%
Jan‐00 Jan‐02 Jan‐04 Jan‐06 Jan‐08 Jan‐10 Jan‐12 Jan‐14 Jan‐16
Fixed income markets
Declining earnings growthYear‐over‐year earnings per share growth has turned negative
High equity market valuationsPrice‐to‐earnings ratios remain high
S&P 500 Index Trailing Quarter P/E RatioS&P 500 Index Trailing 12‐Month Weighted EPS Growth
Credit Suisse High Yield Spread to Worst
?
Average since 2000: 638 bp
U.S. 10‐year Treasury Note
Average since 2000: 3.7%
Trailing 5‐year average: 16.6
Trailing 5‐year average: 6.8%
Data sources: Federal Reserve Bank of St. Louis; Credit Suisse; Bloomberg Finance L.P.; S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn. These opinions represent our good‐faith expectations concerning future actions, events or conditions, and should not be viewed as indications of whether particular actions, events or conditions will occur.
I09-36
Setting the Stage for the FutureCapital Market Assumptions
Asset Classes 2016 Assumptions 2011 Assumptions Difference 2016 Standard Deviation/Risk
EquityU.S. Large Cap 6.6% 9.3% ‐2.7% 16.9%Emerging Markets 8.5% 12.5% ‐3.0% 26.4%Fixed IncomeCore 3.4% 4.2% ‐0.8% 6.0%AlternativesHedge Fund of Funds 5.4% 7.4% ‐2.0% 8.4%
Source: Horizon Actuarial Services, LLC – 2016 Survey of Capital Market Assumptions
I09-37
Greater Macroeconomic Uncertainty
Why we might see increased global equity/credit market dispersion:• Slower economic growth globally• Diverging global monetary policies• Unprecedented central bank actions• Binary macro events like Brexit• Geopolitical risks globally• Potential for U.S. interest rate hikes• Detrimental effects of negative interest rates in Europe and Japan• Decline in inflationary expectations globally• Rising risk of credit-driven crises due to high leverage levels
(China)• Technical factors increasingly driving stock valuationsThese opinions represent our good‐faith expectations concerning future actions, events or conditions, and should not be viewed as indications of whether particular actions, events or conditions will occur.
I09-38
Incorporating Hedged Investment Solutions Today
Hedge Fund-Like Investments Across the Liquidity Spectrum
Liquid Alternatives• Risk Parity• GTAA• Style Premia• Equity Options• 40 Act Alternative
Mutual Funds• Other
HFOFs / Direct HFs• Multi‐Strategy• Strategy‐Specific• Sector‐Specific• Region‐Specific
Illiquid Alternatives• Opportunistic
Beta / Volatility Risk Illiquidity Risk
…Hedge fund‐like exposures come in various shapes, sizes, and liquidity profiles today. Traditional multi‐strategy HFOF vehicles remain viable, but other solutions exist across the
spectrum.
I09-39
62nd Annual Employee Benefits ConferenceNovember 13-16, 2016Orlando, Florida
Session #I09
The Pros and Cons of Hedge Funds
• Be Sure Your Plan Document Allows The Hedge Fund Investment
• Know Who is Fiduciary For Investment—Manager or Trustees?
• Complete and Document Due Diligence• Negotiate Over Contracting• New Investors—Understand What is the Role of the Hedge Fund Allocation
• Existing Investors—Review Why were Hedge Funds Added
• Review Whether or Not Hedge Funds have Met Goals—Have Goals or Expectations Changed?
• Consider Recent Hedge Fund Performance in Light of Current and Potential Market Conditions
• Understand the Evolution of Hedge Fund Products and Alternatives—Including a Consideration of Liquidity Needs
I09-40
2017 Educational ProgramsInvestments
63rd Annual Employee Benefits Conference October 22-25, 2017 Las Vegas, Nevadawww.ifebp.org/usannual
Investments InstituteMarch 13-15, 2017 Phoenix, Arizonawww.ifebp.org/investments
Portfolio Concepts and ManagementMay 1-4, 2017 Philadelphia, Pennsylvaniawww.ifebp.org/wharton
Related ReadingVisit one of the on-site Bookstore locations or see www.ifebp.org/bookstore for more books.
The Tools & Techniques of Investment Planning, 3rd EditionItem #9029www.ifebp.org/books.asp?9029
816
I09-41