Alternative Investment Solutions

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Alternative Investment Solutions
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Contents

• Hedge fund industry characteristics
• size, shape and implications
• risk, return and correlation role within a
  traditional portfolio
• Fund industry analysis
• basic strategy classifications and return sources
• drivers of opportunity and risk
• enhanced strategy classifications
• Research philosophy
• strategy research example

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Contents (Continued)

• Investment process
• strategy clusters, operational due diligence
  cluster, asset allocation cluster and risk
  management cluster
• Client related topics
• mandate discussions
• issues surrounding transparency
• post 1998 environment
• regulatory environment
• industry maturation
• expectations and tolerances
• Conclusion

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Growth of the industry
The Hedge Fund industry continues to grow as more
investors allocate to the asset class
GROWTH OF HEDGE FUNDS (1990 - 2004)
1,000,000
As of Q3
889,838 (E)
900,000
817,492
800,000
700,000
622,304
600,000
536,060
46,588
487,580
ASSETS (USD MILLION)
456,430
500,000
75,084
456,430
374,770
99,436
367,560
400,000
46,544
20,353
256,720
300,000
54,847
185,750
4,406
167,790
200,000
91,431
95,720
57,407
14.698
58,370
100,000
(1,141)
38,190
36,918
27,861
8,463
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Source Hedge Fund Research, Inc.
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Hedge fund industry
Raffaldini ppt.xlsPies?Chart 1
Hedge Funds capital flows are dynamic, and
require an understanding of strategies
Raffaldini ppt.xlsPies?Chart 2
Raffaldini ppt.xlsPies?Chart 1
COMPOSITION IN 1990
COMPOSITION IN 2004
Source Hedge Fund Research
Source Hedge Fund Research
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Hedge funds in a traditional portfolio
Whilst effect of adding hedge funds is to
increase return in long-term, emphasis is placed
on reducing volatility, due to hedge funds lack
of correlation with traditional investments
ANNUALISED RISK RETURN CHART (JANUARY 1990 -
DECEMBER 2003 INCLUSIVE)
Graph is grouped objects
Correlation of HFRI Fund of Funds Index - to MSCI
World 0.42 - to JP Morgan Global Bond Index
-0.07 - to 50 MSCI World, 50 JPM GBI 0.34
Source Bloomberg, Hedge Fund Research Inc.
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Upside participation and loss avoidance
Hedge funds seek to preserve capital during down
months for equities while attempting to benefit
from some of the gain in up months
PERFORMANCE COMPARISON OF THE HFRI FUND OF FUNDS
INDEX DURING POSITIVE AND NEGATIVE MONTHS OF THE
MSCI WORLD EQUITY INDEX JANUARY 1990 - DECEMBER
2003
Average monthly return during 70 negative months
for MSCI World
Average monthly return during 98 positive months
for MSCI World
Graph is grouped objects
Source Bloomberg, Hedge Fund Research Inc.
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Risk control in stress markets
Reduction in volatility is achieved because hedge
funds typically hedge against market risk
SEPTEMBER 2001 RETURNS
Graph is grouped objects, ungroup first to edit
Source Bloomberg, Hedge Fund Research Inc.
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Consistent performance
Excess return in hedge funds during this period
is achieved not by out-performing in good years,
but by preserving capital in bad years, resulting
in much lower volatility
Source Bloomberg, Hedge Fund Research Inc.
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How is this achieved?
Loss avoidance is everything

• Risk control is absolutely paramount. The
  emphasis is on capital preservation, with loss
  defined as loss of capital, not under-performance
  of a benchmark
• The key to understanding this is to appreciate
  the compensation schedule for a hedge fund
  manager
• a management fee, usually around 1
• an incentive profit fee, usually around 20 of
  net new high profits
• The compensation schedule has a profound affect
  in avoiding loss thereby creating a
  non-symmetrical risk-return distribution
• Furthermore, unlike relative return (benchmark
  managers), hedge funds seek to produce absolute
  return
• In the event that market conditions are
  difficult, they can simply raise cash and reduce
  exposure unlike traditional strategies

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Basic classifications
The hedge fund industry has developed a diverse
set of strategies and styles to generate returns
Merger and Credit arbitrage spreads (Risk premia)
Company-specific research (Information)
Price Pattern (Behavior)
Liquidity provision (Risk premia)
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Drivers of risk and return

• Hedge funds attempt to create returns through
• Capturing market risk premia
• Exploiting market inefficiencies
• Risk premium exists to compensate participants
  for assuming risk due to uncertainty
• Markets are inefficient, generally in small ways
  in many places
• Information
• Market structure
• Liquidity
• Behavior
• Skilled operations with the proper tools may take
  advantage of the opportunities

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Strategy classifications
Importance to delineate into the sub-strategy
level given differing sources of risk and return
drivers

• Fundamental Conservative
• Fundamental Aggressive
• Fundamental Short Bias
• Event Equity
• Opportunistic Trading
• Systematic Long / Short

• Systematic
• Discretionary Global Macro
• Discretionary Specialized
• Emerging Markets

• Fixed Income Arbitrage
• Statistical Arbitrage
• Convertible Bond Arbitrage
• Volatility Arbitrage

• Merger Arbitrage
• Credit Long / Short
• Distressed / High Yield
• Multi-Strategy
• Other RV / ED

Note These are the strategy groupings used by
Alternative Investment Solutions
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Research platform
Independent research platform integrates strategy
(top-down) and manager (bottom-up) analyses
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Investment process
StrategyClusters
Operational Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Undertakes research that generates
recommendations on managers within context of
peer group
Evaluates the various non-investment related risks
Generates recommendations on portfolio structure
Ensures risks within portfolios are understood,
intended and compensated
Manager Approval Committee1
Agrees upon a recommended list of managers for
portfolios
Investment Committees
Constructs portfolios based on specific risk and
return targets as it relates to the portfolio
mandate
Notes 1 Does not make portfolio-specific
decisions
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Strategy Cluster
Objective Undertakes research that generates
recommendations on managers within context of
peer group

• Research is underpinned by an in-depth
  understanding of strategy drivers and manager
  differentiation
• Clusters allow global participation and
  coordination of research effort, with resources
  allocated along like skill sets grouping of
  strategies
• Thorough and efficient research designed to
  provide forward-assessment of manager risk and
  return expectations

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Responsibilities of the Strategy Clusters
Continuous review of dynamic factors underlying
each strategys risk and opportunity set
STRATEGY RESEARCH
SOURCING
Identify potential new managers
PRIORITIZING
Organize prospects in order of importance
MANAGER RESEARCH
Managers allocated to a lead SIO and/or IO
Initial Meeting
Establish general overview
Follow-up meetings
Gain comprehensive understanding
PEER ANALYSIS
Compare managers against industry peers on risk
and performance measures
MANAGER MONITORING
On-going manager monitoring to generate buy, hold
or sell recommendation
MANAGER RECOMMENDATIONS
Sponsored by CIO or SIO
StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Operational Due Diligence Cluster
Objective evaluates the various non-investment
related risks
Key points include

• Determine whether existing infrastructure enables
  the manager to focus on generating returns
• Assess the scalability of the operations relative
  to the strategies employed
• Establish a channel of communication between
  Alternative Investment Solutions and the hedge
  fund back office operations
• Establish an understanding of information and
  timelines expected

StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Responsibilities of the Operational Due Diligence
Cluster
RECEIVE FUND OVERVIEW
Receives overview of the manager from respective
strategy cluster
DUE DILIGENCE QUESTIONNAIRE
Send questionnaire to manager and review once
returned
SECURITY CHECKS
Instigate independent UBS security checks
Meet senior members of the managers logistics
teams
MANAGER MEETING
IOs generate and submit a report to the Manager
Approval Committee
REPORT GENERATION
Regular monitoring and discussions with the
manager
MONITORING
StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Manager Approval Committee
Objective agrees a recommended list of managers
for portfolios

• Draws on the output from the Strategy and
  Operational Due Diligence Clusters
• Committee comprises the Senior Investment
  Officers of the group and is chaired by CIO
• Committee meets formally on a monthly basis
• Discusses and debates occur informally on an
  intra-month basis
• Managers are approved by a two thirds majority
  where a quorum is defined as a minimum of four
  voting members
• The Committee also determines managers to be
  removed from the recommended list

StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Asset Allocation Cluster
Objective generates recommendations on portfolio
structure

• Iterative approach considering manager
  availability, strategy research and
  macro-economic views
• Recommendations on strategy allocation framework
  based on economic considerations, strategy
  developments and risk
• Rather than rely solely on traditional mean
  variance optimization, strategy recommendations
  also utilize other quantitative techniques
• This avoids problems inherent in historical
  modeling that occur when faced with
  non-predictive factors

StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Responsibilities of the Asset Allocation Cluster
MACRO ENVIRONMENT
Assess global macro economic trends
STRATEGY OPPORTUNITIES
Qualitative assessment of strategy opportunity set
RISK/REWARD ANALYSIS
Estimate risk/reward for each strategy
Develop asset allocation recommendation for each
unique mandate
ASSET ALLOCATION RECOMMENDATION
StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Risk Management Cluster
Objective ensures risks within portfolios are
understood, intended and compensated

• Assesses the balance of risk and reward within
  the portfolio in both normal and stress market
  conditions
• Relevant risk factors are gathered in order to
  analyze fund performance and risk at both manager
  and portfolio level
• Qualitative and quantitative analysis increases
  the robustness of the portfolio construction
  process

StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Responsibilities of the Risk Management Cluster
QUANTITATIVE MANAGER REVIEW
Analytical decomposition of fund performance
QUANTITATIVE PORTFOLIO REVIEW
Performance-based analysis of portfolio risks,
and the relation between investments
RISK ASSESSMENT
Aggregate components of manager risk and at the
portfolio level
SCENARIO/STRESS ANALYSIS
Multifactor models to explain performance in
normal and stress environments
Continuously monitoring of actual versus targets,
benchmarks and peers
RISK LIMIT OVERSIGHT
PORTFOLIO RECOMMENDATIONS
Quantitative recommendations regarding
incremental portfolio risk of an investment
StrategyClusters
Ops. Due Diligence Cluster
Asset Allocation Cluster
Risk Management Cluster
Manager Approval Committee
Investment Committee
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Mandate discussion

• Establish expectations for return, risk and
  correlation (both for normal market environments
  and stress)
• Client constraints are established, examples
  include
• strategy exposure
• types of managers
• manager concentration
• Controlling risk is much easier than controlling
  return
• Alternative Investment Solutions considers itself
  a risk manager that manages a portfolio rather
  than a portfolio manager that manages risk

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Issues surrounding transparency
There are many views on the feasibility and
importance of total transparency

• Question comes down to risk measurement versus
  risk management
• Hedge fund managers generally reluctant to
  provide full disclosure given that other market
  participants can use this information to their
  advantage
• particularly relevant when short positions,
  controversial and illiquid securities are
  involved
• What level of disclosure is necessary to perform
  effective and pro-active investment monitoring?
• Is position level reporting as useful as costs
  associated with it or the negative selection bias
  it can create?
• Importance of relevant risk factors,
  value-at-risk analysis, stress tests, position
  concentration and Greeks that are unique to
  each fund strategy and sub-strategy
• detail analysis without the disclosure of
  sensitive information
• The role of pro-active forward looking
  qualitative monitoring should NOT be
  underestimated

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Post 1998 environment
Aftermath since LTCM

• How has the hedge fund industry changed since
  1998?
• Increased appreciation of dangers of excessive
  leverage and strategies that overly rely on it
  for profit (i.e. certain types of fixed income
  arbitrage trades)
• there has been a large outflow of assets from
  hedge funds that use these approaches
• Limitations of value-at-risk in event of major
  systemic shock (the one in a hundred year
  scenario) and increased usefulness in stress
  testing portfolios
• importance of understanding the shifting risks to
  both a single hedge fund manager and a portfolio
  during normal and shock market environments
• Outcome has been a general decline in leverage
  across wide variety of strategies as evidenced by
  lower stress losses in 9/11
• In addition, various global regulatory
  authorities are beginning to dedicate more time
  and resources to analyzing the hedge fund
  industry and their role within the financial
  markets

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Regulatory environment
Greater Oversight

• Trading areas
• Particular analysis is on relationship between
  research and trading within the sell side
  community and as it relates to hedge funds
• Rules to restrict or increase the difficulty of
  short selling would have negative effect on hedge
  funds not only are shorts alpha generating (bad
  companies with bad business models that are
  failing) but also are exposure reducing (like
  pair trading)
• Non-trading areas
• In the US, the source of funds (Patriot Act
  requirements)
• SEC Hedge Fund Act Registration (as opposed to
  Regulation) is an important underpinning for
  investor confidence
• Markets/countries that have placed restrictions
  on hedge fund activities have seen liquidity
  levels and traditional investor interest decline
  sharply

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Industry maturation
Is there a hedge fund bubble?

• Recent asset inflows into hedge funds have been
  strong
• Nevertheless, hedge funds account for less than
  6 of total market value of traditional long-only
  world of all financial assets
• It is important to understand not just the
  absolute level of inflows but also to which
  strategies the inflows are going
• large inflows currently going to strategies that
  need additional capital such as credit
  derivatives and other evolving new markets
• Hedge fund performance is cyclical and profitable
  arbitrage situations ebb and flow
• Certain strategies tend to be counter-cyclical to
  each other (like merger arbitrage and distressed
  credit), namely a diminished opportunity set in
  one strategy frequently leads to improving profit
  potential in the other
• Hence, importance of a broad based portfolio to
  capture the changing opportunity sets of various
  strategies

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Expectations and tolerances
Setting these before investing is important

• Risk free interest rate alpha beta
• Libor is a good proxy for the level of interest
  rates
• Alpha is the ability to profit from either hedge
  fund manager selection (selection effect) and
  strategy allocation (allocation affect). These
  typically average around 6 net a year
• Beta is the intended and unintended market
  movement of a portfolio. Since broad based fund
  of funds portfolios function as a diversifier,
  over time the beta can average around 0.20 to an
  index like the SP 500

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Expectations and tolerances (contd)
Setting these before investing is important

• Given this equation, when fund of funds generated
  an annual return of 14 in the late 1990s, it was
  composed of an average Libor of 6, 6 in alpha
  and 2 in beta (.20 beta 10 average gain in
  the SP 500)
• In 2002 the performance for most fund of funds
  was 3, with Libor at 2, 6 in alpha and -5
  beta (.20 beta -25 loss in SP)
• All of this should be accomplished with an
  annualized volatility between 3 to 5, a worse
  monthly loss between 1 to 2 and generating
  profitability 75 to 80 of all months

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Allocation Issues

• The decision to invest in hedge funds frequently
  comes down to two choices invest directly or
  through a fund of fund
• Investing directly avoids an additional layer of
  fees but introduces issues surrounding manager
  selection issues (access and return dispersion)
  and manager monitoring issues (disclosure and
  resources)
• Investing in a fund of fund product avoids this
  issues but comes with an additional layer of fees
• A common approach is to initially invest in a
  broad based fund of fund product then, over time
  and as experienced is gained, direct investments
  are made to multi-strategy single hedge funds
• This model is frequently referred to as
  core-satellite, with the fund of funds
  representing the core 75 to 80 allocation while
  the satellite direct investments make up the
  balance
• The ultimate decision is as unique as the
  individual plan sponsors business model and needs

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Conclusion

• Broad based hedge fund portfolios belong in any
  investment portfolio due to the unique role they
  perform when combined with traditional asset
  classes
• Non-correlated sources of alpha benefit any
  portfolio, and should always be incorporated, no
  matter what their source (hedge funds, real
  estate, private equity, timber etc)
• Opportunities will continue to exist
• The ability to perform regulatory arbitrage and
  lock up money is a key component in capturing
  alpha
• Existing financial markets will inevitably grow
  in tandem with real economies and new strategies
  develop to exploit dislocations
• Given these factors, the most logical question is
  not whether to invest or not but what are the
  appropriate allocation levels to make to a
  traditional portfolio

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Disclaimer
Alternative Investment Solutions prepared the
information, including but not limited the charts
and graphs, contained within this presentation.
Unless otherwise noted, the information used to
create these charts and graphs was based solely
on information collected and retained in
Alternative Investment Solutions proprietary
database and is accurate as of the date so
indicated on the particular chart or graph. Third
party funds and managers contributed to the
majority of the information collected therefore,
Alternative Investment Solutions makes no
representations as to the accuracy of such source
information and the charts and graphs are subject
to change without notice to the recipient. As
such, the charts and graphs do not purport to be
a scientific or academic analysis but rather,
represent some measure of support for the
experientially based opinions of Alternative
Investment Solutions. This document does not
constitute an offer of securities. Such an offer
will only be made by means of a confidential
offering memorandum. This material is
confidential and intended solely for the
information of the person to whom it as been
delivered. Recipients may not reproduce or
transmit it, in whole or in part, to third
parties. Past performance is not indicative of
future results and future results may differ
significantly from current or historical
returns. This document has been issued through
UBS OConnor Limited for distribution to
Intermediate or Market Counterparty customers and
through UBS Global Asset Management (US) Inc. UBS
OConnor Limited (authorized and regulated by the
Financial Services Authority in the UK) and UBS
Global Asset Management (US) Inc. (a member of
NASD and SIPC) are subsidiaries of UBS AG.
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• Americas
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