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INVESTMENT VOLATILITY: ARE ALTERNATIVES AN ALTERNATIVE

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Title: INVESTMENT VOLATILITY: ARE ALTERNATIVES AN ALTERNATIVE


1
INVESTMENT VOLATILITY ARE ALTERNATIVES AN
ALTERNATIVE?
  • Council on Foundations Annual Conference
  • April 28, 2003
  • Edward B. Kacic, Irvine Health Foundation
  • Bruce Madding, Kaiser Family Foundation
  • Jim Martin, M.J. Murdock Charitable Trust

2
Todays Discussion
  • What Well Cover
  • Alternatives 101
  • Introduce Concepts
  • Discuss Types of Alternative Assets
  • Discuss Use of Alternatives
  • Discuss Benefits and Potential Pitfalls

3
Todays Discussion
  • What We Wont Cover
  • Investments 101
  • Basic Asset Allocation
  • In-Depth Details of Sub-Strategies
  • Sales Pitches for Specific Products

4
Glossary What We Mean
  • Volatility Standard deviation of returns
  • Correlation Coefficient Degree to which assets
    move in relation to one another (always expressed
    as range of -1 to 1)
  • Alpha Excess return (e.g., returns that exceed
    benchmark)

5
Glossary What We Mean
  • Beta Sensitivity of an asset/portfolio to the
    movement of the market (Market beta equals 1.
    Beta of 1.1 indicates asset is expected to move
    10 more than the market)

6
What Are Alternatives?
  • Non-traditional Strategies
  • Debt, Equity, and/or Real Assets
  • Lower Correlation to Traditional Assets
  • Can Contribute to Lower Portfolio Volatility
  • Can Contribute to Higher Expected Return

7
Types of Alternative Investments
  • Commonly Described
  • Private Equity
  • Private Debt
  • Venture Capital
  • Absolute Return
  • Hedge Funds
  • Real Estate
  • Natural Resources
  • Commodities/Futures
  • Well Call Them
  • Private Equity
  • Hedge
  • Real Assets
  • Not Discussed Here

8
Investment Methodologies
  • Direct Investment
  • Partnerships
  • Funds
  • Funds of Funds

9
Considerations
  • Asset Allocation
  • Liquidity
  • Finding Appropriate Investments
  • Minimum Investment Requirements

10
Considerations
  • Expected Returns
  • Performance Evaluation
  • Fees
  • Legal Issues

11
Types of Alternative Investments
  • Commonly Described
  • Private Equity
  • Private Debt
  • Venture Capital
  • Absolute Return
  • Hedge Funds
  • Real Estate
  • Natural Resources
  • Commodities/Futures
  • Well Call Them
  • Private Equity
  • Hedge
  • Real Assets
  • Not Discussed Here

12
Council on Foundations54th Annual
ConferenceDallas, TexasApril 28 30,
2003
  • Investment Volatility
  • Are Alternatives an Alternative?
  • Jim Martin
  • 400 pm 530 pm
  • Monday, April 28, 2003

13
Discussion
  • Jim Martin Background
  • M. J. Murdock Charitable Trust
  • Overview
  • Asset Allocation Policy/History
  • Return Expectations/Risk
  • Volatility
  • Alternatives - Traditional Asset Classes

14
Discussion
  • Alternatives M. J. Murdock Charitable Trust
  • Alternatives Issues to Consider
  • Direct or Fund-of-Funds Investing
  • Performance Measurement Considerations
  • Historical Returns

15
Jim Martin Background
  • Deloitte Touche
    (formerly, Deloitte Haskins Sells)
  • 18 years
  • Partner
  • M. J. Murdock Charitable Trust
  • 1987 Present
  • Chief Investment and Financial Officer

16
Jim Martin Background
  • Registered Investment Advisor
  • Manage Approximately 125 million on Fully
    Discretionary Basis
  • Investment Committees
  • Sunkist (200 mil)
  • Rasmuson Foundation (425 mil)
  • Boy Scouts Cascade Pacific Council (1.2 mil)
  • Vancouver Rotary Foundation (1.2 mil)
  • Red Cross Clark County, Washington (1.4 mil)
  • Community Foundation of Southwest Washington (30
    mil)

17
M.J. Murdock Charitable Trust Overview
  • Private Foundation
  • Vancouver, Washington
  • 460 Million
  • Formation
  • Jack Murdocks Estate - 1975
  • Tektronix Co-Founder
  • Assets at Inception
  • 91 million
  • Grantmaking
  • Five Northwest States
  • Cumulative Grants Since Inception 386 million
  • Primarily Scientific Research and Education

18
M.J. Murdock Charitable TrustAsset Allocation
Policy/History
19
M.J. Murdock Charitable TrustReturn
Expectations/Risk
20
Volatility
  • Volatility
  • Not Your Friend
  • Career Risk
  • Standard Deviations Measurement
  • Extreme Volatility
  • Any Asset
  • Any Investment
  • Biggest Risk
  • Not Having Dollars When Needed

21
Volatility
  • Minimizing Volatility
  • Multiple Asset Classes
  • Asset Class Diversity
  • Use Alternatives
  • Non-Product Correlation
  • Asset Class Return Guarantee

22
Alternatives Traditional Asset Classes
  • Alternatives Non-Traditional Products
  • Not Long Only Bonds or Equities
  • Looks Like A Duck Sounds Like a Duck
    Alternative
  • Modeled Risk/Return Characteristics
  • Asset Class
  • Capital Preservation
  • Murdock Trust Example

23
Alternatives M. J. Murdock Charitable Trust
  • Various Options
  • M. J. Murdock Charitable Trust Structure
  • Private Equity
  • Venture Capital
  • Private Placements
  • Oil and Gas
  • Mezzanine
  • Secondaries
  • Global
  • Distressed Securities
  • Hedge Funds
  • Other

24
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30
AlternativesIssues to Consider
  • Liquidity Need
  • Cash Flow
  • Building the Class and Distributions back
  • Commitment Sizes
  • 10- to 15-year Product Commitments
  • Valuations
  • Daily, Monthly, Quarterly, Annual
  • Perceptions
  • Constituency
  • Other Interested Parties

31
Direct or Fund-of-Funds Investing
  • Invest Direct
  • For the Big Boys
  • Significant Assets
  • Minimum Requirements
  • Prudent Diversification
  • Diversification
  • Type
  • Vintage Year

32
Direct or Fund-of-Funds Investing
  • Fund-of-Funds
  • Diversification
  • Expertise
  • Due Diligence Leveraging
  • Fees

33
Performance Measurement Considerations
  • Private Equity Investments
  • Not Marked to Market
  • Best Measurement
  • IRR?
  • Time Weighted Returns?
  • Cash Flow Multiples?
  • Combination Thereof or Hybrid?
  • Combining Alternative and Traditional Asset Class
    Return

34
Historical Returns
35
Historical Returns
36
Questions?
37
Types of Alternative Investments
  • Commonly Described
  • Private Equity
  • Private Debt
  • Venture Capital
  • Absolute Return
  • Hedge Funds
  • Real Estate
  • Natural Resources
  • Commodities/Futures
  • Well Call Them
  • Private Equity
  • Hedge
  • Real Assets
  • Not Discussed Here

38
What really is a hedge fund?
  • The term hedge fund is a catchall that applies
    to thousands and thousands of investment funds of
    all strategies. A hedge fund can be any limited
    partnership thats constructed in such a way as
    to give the general partners the managers of
    the fund a share of the profits earned on the
    limited partners money.
  • - Andy Serwer Carol Loomis, Fortune

Council on Foundations April 28, 2003
39
Hedge Funds Defined
  • Private pooled investment vehicles
  • Short positions, derivatives, leverage, hedging,
    arbitrage
  • Normally charge an incentive fee based on fund
    performance
  • Specialized, skill-based alternative investment
    strategies
  • Seek to capitalize on pricing inefficiencies

Source Northern Trust CIS Conference 2001
Council on Foundations April 28, 2003
40
Why Invest?
  • Diversification of equity market risk
  • Higher comparative liquidity
  • Positive returns in negative market environments

Source Northern Trust CIS Conference 2001
Council on Foundations April 28, 2003
41
Short Term Performance
Source EIM Group Presentation, The Promise and
the Reality of Hedge Fund Investing
Council on Foundations April 28, 2003
42
Long Term Performance
Source EIM Group Presentation, The Promise and
the Reality of Hedge Fund Investing
Council on Foundations April 28, 2003
43
Hedge vs. Greater Market
HFRI vs. Greater Market Indices
Council on Foundations April 28, 2003
44
Historical Risk/Returns
Source EACM
Council on Foundations April 28, 2003
45
Steps to develop a hedge fund portfolio
  • Articulate your investment beliefs
  • Management of complexity
  • Understanding all the strategies
  • Automation, database management, well-defined
    processes
  • Search for unique sources of alpha
  • Undertaking individual manager due diligence
  • Advanced Portfolio Construction
  • Name, measure and immunize the portfolio from as
    many potential shocks as possible
  • Structuring the portfolio to meet the
    organizations risk and return expectations
  • - Northwater Capital Management

Council on Foundations April 28, 2003
46
Alternative Asset Program Objectives
  • Define Objectives of the Program
  • Diversification
  • Low correlation to equity market
  • Low volatility to equity market
  • Expected return inflation 8
  • AGGRESSIVE
  • Outperform broad equity
  • market w/ 60-80 of volatility
  • Significant directional risk
  • CONSERVATIVE
  • Low volatility/low return
  • Emphasis on diversification
  • MODERATE
  • Some equity market directional risk
  • Volatility 1/3 of equity market

Council on Foundations April 28, 2003
47
Hedge Fund Categories
  • Relative Value
  • Long/Short Equity
  • Convertible Arbitrage
  • Fixed Income Arbitrage
  • Market Neutral Equity Arbitrage
  • Multi-Strategy Hedge
  • Event-Driven
  • Deal Arbitrage
  • Bankruptcy/Distressed
  • Multi-Strategy
  • Equity Hedge Funds
  • Long Biased
  • Opportunistic
  • Global/International
  • Global Asset Allocators
  • Discretionary
  • Systematic
  • Short Selling

Council on Foundations April 28, 2003
48
Hedge Fund Spectrum
Hedge funds cover a broad spectrum of risk/return
characteristics
Global Macro
Emerging Equities Managed
Futures Dedicated Short Bias
Market Timing Long/short
Equity Distressed Securities Fixed Income
Arbitrage Convertible Arbitrage
Merger Arbitrage Equity Market Neutral
Return
Low Volatility High
Council on Foundations April 28, 2003
49
Choosing Appropriate Strategies
Define Objectives of the Program
  • Conservative Strategies
  • - Distressed Securities (Senior)
  • Diversified Arbitrage
  • (Low/No Leverage)
  • Event Arbitrage
  • Market Neutral
  • (Broad Market Sectors)
  • Moderate Strategies
  • Convertible Arbitrage
  • Distressed Securities (Post Bankruptcy)
  • Diversified Arbitrage
  • (Some Leverage)
  • Event Arbitrage (Higher Risk Deals)
  • Market Neutral
  • Short-Biased
  • Long/short US Equity (No Leverage)
  • Aggressive Strategies
  • Global Long/Short
  • Global Macro (Leveraged)
  • Long/short US Equity (Concentrated Value or
    cap-size focus)
  • Sector Funds
  • (Sector Directional Risk)

Council on Foundations April 28, 2003
50
Kaiser Hedge Allocations
Council on Foundations April 28, 2003
51
Diversification through Partnerships and Fund of
Funds
Conservative Strategies
Moderate Strategies
Aggressive Strategies
Defined Target Allocations for each strategy (8
to 10 funds total)
Partnership Investments Only
Fund of Funds and Partnerships
Fund of Funds Only
  • Achieve Objectives of the Program
  • Diversification
  • Low correlation to equity market
  • Low volatility to equity market
  • Expected return inflation 8

Council on Foundations April 28, 2003
52
Accessing Absolute Return Strategies
  • Direct Investment
  • Pros Greater Control
  • Cons Research intensive, administratively
    burdensome, manager cross correlation
  • Consultant
  • Pros Greater diversification, consolidation of
    information
  • Cons Not fully immersed in industry knowledge,
    probable manager cross correlation
  • Fund of Funds
  • Pros Low correlation b/w managers, greater
    liquidity, low minimum investment increases
    access for smaller investors, consolidation of
    information, expertise
  • Cons Higher fees

Council on Foundations April 28, 2003
53
Due Diligence
  • Try to determine whether past performance is
    sustainable
  • Look at stability
  • Administration and back office
  • Minimum 3 year track record preferable
  • Evaluate qualitative ability in judgment

Council on Foundations April 28, 2003
54
Risks
  • Blundered, blown-up or defrauded
  • investors at fairly regular intervals
  • - The Economist
  • Chicago Art Institute
  • Lipper
  • Long Term Capital
  • Askin Capital
  • Eifuku

Council on Foundations April 28, 2003
55
Eifuku good fortune?
  • Eifuku Master Fund, a 300 million hedge fund,
    in Japan is being wound down after losing
    virtually all its capital in just seven trading
    days in early January. The swift reversal in the
    fund, which was up 76 in 2002, shows just how
    volatile hedge funds can be.
  • - Henny Sender Jason Singer, Wall
    Street Journal

Council on Foundations April 28, 2003
56
Failed Funds
  • Overall about 750 hedge funds closed up shop
    last year, or about 14 of all funds, up from
    11
  • - Henny Sender Gregory Zuckerman, Wall
    Street Journal

Council on Foundations April 28, 2003
57
Optimization
  • As with real estate and private equity, hedge
    funds offer optimization techniques to imperfect
    input data for all three parameters, risk, return
    and correlation. This is due to infrequent and
    sometimes imperfect mark-to-markets, survivor
    bias and relatively short return histories.
  • - Northwater Capital Management

Council on Foundations April 28, 2003
58
Risks
  • Whether or not it is a bubble or a gold rush no
    one disputes that it is certainly a craze
  • - Growing concerns that not all the money that
    has been raised can be allocated

Council on Foundations April 28, 2003
59
Risks
  • You Cannot Scale Talent
  • - Stephen Oxley of Watson Wyatt
  • Headline Risk
  • No Transparency
  • Higher Costs
  • Turnover

Council on Foundations April 28, 2003
60
Fierce secrecy
  • My client called up this hedge fund he had a big
    chunk of money in to ask generally about its
    positions and they basically told him, None of
    your business. And it was his money!
  • - Anonymous fund of funds manager

Council on Foundations April 28, 2003
61
Survey of Pension Plans
Does your plan allocate or intend to allocate to
higher risk strategies like alternative
investments private equity, venture capital, and
hedge funds?
The survey was conducted on 205 investment
officers from corporate, public, and union funds.
12 of funds reporting held more than 10
billion in assets, 42 had 1-9.9 billion, 21
had 500 million - 1 billion, and 25 had 200
million - 499 million.
Council on Foundations April 28, 2003
Source Fidelity Viewpoint, Winter 2003
62
Bibliography/Resources
  • Pioneering Portfolio Management An Unconventional
    Approach to Institutional Investment. David F.
    Swensen. The Free Press, 2000.
  • Hedge Funds Investment and Portfolio Strategies
    for the Institutional Investor. Jess Lederman
    Robert Klein, editors. Irwin Professional
    Publishing, 1995.
  • The Handbook of Alternative Investment
    Strategies. Thomas Schneeweis, Joseph F.
    Pescatore, editors. Institutional Investor, 1999.

63
Bibliography/Resources
  • Evaluating and Implementing Hedge Fund
    Strategies, second edition. Ronald A. Lake,
    editor. Euromoney books, 1999.
  • The Money of Invention How Venture Capital
    Creates New Wealth. Paul A. Gompers and Josh
    Lerner. Harvard Business School Press, 2001.

64
Bibliography/Resources
  • Journal of Alternative Investments.
    Institutional Investor. www.iijai.com.
  • National Assn. of Real Estate Investment Trusts
    www.nareit.com
  • National Council of Real Estate Investment
    Fiduciaries www.ncreif.com

65
Bibliography/Resources
  • Managed Account Reports www.marhedge.com
  • Venture Capital Institute www.vcinstitute.org
  • Venture Economics www.ventureeconomics.com
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