Hedge Fund Primer. Hedge Fund Primer

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2 Hedge Fund Primer Hedge Fund Primer

3 INVESTMENT PRODUCTS: NOT FDIC INSURED NOT A BANK DEPOSIT MAY LOSE VALUE

4 HEDGE FUND PRIMER A Guide to Investing in Hedge Funds I N S I G H T Hedge funds have the potential to produce attractive absolute returns, with generally low correlations to traditional investments. Over the past decade, the hedge fund market has seen the number of new managers proliferate and the growth of hedge fund assets accelerate sharply. In December 2007, it was estimated that there were over 7,500 active hedge funds totaling just under $2 trillion in assets under management. Several factors are responsible for the growth and interest in hedge funds. The bull market of the late 1990 s was a tremendous source of asset growth for investors, but the subsequent fall in equity returns (and estimates of lower future returns) have caused investors to seek new sources of return as well as opportunities for diversification. Moreover, hedge funds have the potential to produce attractive absolute returns, with generally low correlations to traditional investments, so they are considered useful complements to traditional investment strategies. However, as with any type of investment, there are specific risks associated with hedge fund strategies that must be clearly understood by investors. This guide is designed to improve investors understanding of the potential benefits and risks of hedge funds, and the role they can play in a diversified portfolio of traditional and alternative investments. Figure 1 GROWTH OF THE HEDGE FUND INDUSTRY (As of December 31, 2007) I N S I D E INTRODUCTION TO HEDGE FUNDS 1 WHAT IS A HEDGE FUND? 2 WHO INVESTS IN HEDGE FUNDS? 2 HEDGE FUND STRATEGIES 2 STRATEGY CORRELATIONS 5 POTENTIAL BENEFITS 5 POTENTIAL RISKS 5 HEDGE FUND STRUCTURES 7 FEE STRUCTURES 7 CONCLUSION 7 HEDGE FUND GLOSSARY 8 IMPORTANT INFORMATION 9 Number of Funds 9,000 8,000 # of Funds Assets Under Mgmt 7,000 6,000 5,000 4,000 3,000 2,000 1,000 $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 0 $0 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 Source: Hedge Fund Research, Inc. 4Q07 Industry Report. Number of funds excludes funds of hedge funds. Assets (in $Billions) 1 Hedge Fund Research, Inc., HFR 4Q07 Industry Report. See important disclosure about alternative investments. 1

5 WHAT IS A HEDGE FUND? Investors are often surprised to learn that hedge funds have actually been in existence since 1949, when sociologist and financial journalist Alfred Winslow Jones was researching an article for Fortune magazine and formed a private investment partnership to use as an investment system that he had devised. The basis for Jones approach entailed hedging his long stock positions by selling short other stocks to seek to protect against market risk (the possibility that a stock will lose value due to a general decline in stock prices). In doing so, he also used leverage (borrowed money) in seeking to enhance his portfolio s potential return. Over time, the term hedge fund has taken on a broader meaning. A hedge fund can be thought of as an investment structure for managing a private, less-regulated investment pool that can invest in both physical securities and derivative markets on a leveraged basis. Legally, it may take the form of a limited partnership, corporation, trust or mutual fund, depending on where the fund is domiciled and the type of investors it seeks to attract. The domicile or legal location of the hedge fund determines its structure. Most U.S.-based hedge funds are structured as limited partnerships, while hedge funds outside the U.S., or offshore funds, are typically structured as limited liability companies. 2 As with more traditional styles of management, hedge funds are managed in either a separate account or, more typically, a commingled fund. The hedge fund structure gives investors access to hedge fund managers with specialized investment skills. Unlike traditional asset managers, many hedge fund managers try to create value primarily through positions uncorrelated with systematic exposure to capital markets. Instead, they typically seek to generate portfolio performance regardless of the direction of the capital markets. 3 Hedge fund managers typically seek to generate attractive absolute returns regardless of the direction of capital markets. WHO INVESTS IN HEDGE FUNDS? Traditionally, the largest group of hedge fund investors has been ultra-affluent private individuals. In fact, throughout the 1980 s, investors in hedge funds were almost exclusively high net worth private investors. Private investors dominate hedge funds because they are typically more willing to pursue higher absolute returns and to bear the higher risks that often accompany those higher returns. In contrast, the strict fiduciary responsibilities of many institutional investors have made them slower to include hedge fund strategies in their investment portfolios. Starting in the 1990 s, the investor base began to broaden to include corporate pension plans, insurance companies, endowments, foundations and public funds. Although high net worth individuals primarily have been the main investors in hedge funds, institutional investors such as pension funds and endowments (where state regulations or fund guidelines permit) have recently been a growing presence in the hedge fund industry. This greater interest by institutional investors has created a larger asset base for the hedge fund industry and has given institutional investors, which commonly require higher degrees of transparency, more influence over the practices of hedge fund managers. For example, in July 1990, the Yale University Endowment Fund became the first institutional investor to pursue absolute return strategies as a distinct asset class, beginning with a target allocation of 15%. As of June 30, 2007, the $18.0 billion Yale University Endowment Fund had a 23.3% allocation to absolute return strategies. 4 Currently, there are some specific limits placed on the number and types of investors that hedge funds can accept. Only qualified purchasers are eligible to invest in hedge funds that have been structured to employ the registration exemption allowed by Section 3(c)(7) of the Investment Company Act of Qualified purchasers are individuals or family entities (i.e., family limited partnerships, limited liability companies and trusts) with minimum net investable assets of $5 million, or other entities such as corporations, U.S. endowments and foundations with minimum net investable assets of $25 million. More recently, the industry has seen an outgrowth of SEC registered hedge funds that are less restrictive. These registered funds generally have no limit on the number of investors they may accept and have lower eligibility requirements. Generally, investors must meet the standards for an accredited investor, which require a net worth of $1 million and/or an annual income of at least $200,000 for the past two years for individuals and $5 million total assets for entities. HEDGE FUND STRATEGIES In order to develop a coherent plan to invest in hedge funds, it is important to understand the sources of return for each strategy and to recognize the risk exposures underlying each investment. The following is a discussion of the primary hedge fund strategies utilized. Directional Equity Long/Short Equity funds take long and short stock positions. The manager may attempt to profit from both long and 2 2 Investing in Hedge Funds Strategies for the New Marketplace, Joseph G. Nicholas, Chairman, Hedge Fund Research, L.L.C., 1999 Bloomberg Press 3 Investing in Hedge Funds Strategies for the New Marketplace, Joseph G. Nicholas, Chairman, Hedge Fund Research, L.L.C., 1999 Bloomberg Press 4 Yale University Endowment Annual Report, June 2007.

6 short stock positions independently, or profit from the relative outperformance of long positions against short positions. The stock picking and portfolio construction process is usually based on bottom-up fundamental stock analysis, but may also include top-down macro-based views, market trends and sentiment factors. Long/Short Equity managers may specialize by region (e.g., global, U.S., Europe or Japan) or by sector. No assurance can be given that the managers will be able to correctly locate profitable trading opportunities, and such opportunities may be adversely affected by unforeseen events. In addition, short selling creates the risk of loss if the security that has been sold short appreciates in value. Emerging Markets Emerging Market funds invest in securities of companies or the sovereign debt of developing or emerging countries. Investments are primarily long. Emerging Markets include countries in Latin America, Eastern Europe, the former Soviet Union, Africa and parts of Asia. Emerging Markets funds will shift their weightings among these regions according to market conditions and manager perspectives. In addition, some managers invest solely in individual regions. However, although there are high return potentials in many regions, there are also correspondingly high price fluctuations. Investors could discover that the countries into which they have put their money have run out of cash, and that the value of their investments has dropped sharply. International investing involves special risk considerations, including economic and political conditions, inflation rates and currency fluctuations. Equity Non-Hedge Equity Non-Hedge funds are predominately long equities although they have the ability to hedge with short sales of stocks and/or stock index options. These funds are commonly known as "stock-pickers." Some funds employ leverage to enhance returns. When market conditions warrant, Figure 2 HEDGE FUND MARKET COMPOSITION BY STRATEGY (As of December 31, 2007) Relative Value 15% Fixed Income 6% Global Macro 11% Event Driven 24% managers may implement a hedge in the portfolio. Funds may also opportunistically short individual stocks. The important distinction between equity non-hedge funds and equity hedge funds is equity nonhedge funds do not always have a hedge in place. In addition to equities, some funds may have limited assets invested in other types of securities. Directional Macro Equity Non-Hedge 4% Directional Macro strategies require welldeveloped risk management procedures due to the frequent employment of leverage. Investment Managers may trade futures, options on future contracts and foreign exchange contracts and may trade in diversified markets or focus on one market sector. Two types of strategies employed by directional macro managers are discretionary and systematic trading. Discretionary Trading strategies seek to dynamically allocate capital to relatively short-term trading opportunities around Emerging Markets 5% Equity Market Neutral 2% the world. Directional strategies (seeking to participate in rising and declining when the trend appears strong and justified by fundamentals) and relative value approaches (establishing long positions in undervalued instruments and short positions in related instruments believed to be over valued) or in spread positions in an attempt to capture changes in the relationships between instruments. Systematic Trading strategies generally rely on computerized trading systems or models to identify and capitalize on trends in financial and commodity markets. This systematic approach allows investment managers to seek to take advantage of price patterns in very large number of markets. The trading models may be focused on technical or fundamental factors or combination of factors. Relative Value Equity Long/Short 33% Source: Hedge Fund Research, Inc. 4Q07 Industry Report. Number of funds excludes funds of hedge funds. Market conditions will change over time. Relative Value strategies seek to take advantage of specific pricing anomalies, while also seeking to maintain minimal exposure to systematic market risk. 3

7 This may be achieved by purchasing one security previously believed to be undervalued, while selling short another security perceived to be overvalued. Relative value arbitrage strategies include equity market neutral, statistical arbitrage, convertible arbitrage, and fixed income arbitrage. Some investment managers classified as multi-strategy relative value arbitrage use a combination of these substrategies. Equity Market Neutral-Fundamental Equity Market Neutral funds take both long and short positions in equities. Related short positions hedge out much of the systematic risk in the long positions on either a dollar- or beta-adjusted basis so that the overall portfolio has a limited exposure to market moves. Stock positions are usually diversified, so that no one position has a disproportionate effect on the portfolio. However, to the extent a balanced position is unable to be maintained, the strategy will not be market neutral. In addition, to the extent that long and short positions don t match up within an industry or sector, a price move that affects only one industry or sector, rather than the overall market, may result in losses from an entire industry s or sector s performance, rather than stock-picking losses. Equity Market Neutral Statistical Statistical funds use a relative value, systematic trading strategy that seeks to exploit short- and long-term relationships among stock prices and volatility. Trading in this strategy can be based on proprietary models that focus on short-term corporate events and structural relationships between stocks, or longer-term models that focus on the predicted shape of a given stock s price distribution. Models that have been formulated on the basis of past market data may not be predictive of future price movements. Models selected may not be wellsuited to prevailing market conditions. Furthermore, the effectiveness of such models tends to deteriorate over time as more traders seek to exploit the same market inefficiencies through the use of similar models. Fixed Income Fixed Income funds seek to exploit the relative values of fixed income instruments. The manager takes positions in government bonds and investment-grade corporate bonds, government agency securities and swap contracts, and futures and options on fixed income instruments. Usually, the manager constructs the portfolio on a market neutral basis and often constrains it to be duration neutral within a given country (often, the developed countries). However, such positions do entail a substantial risk that the price differential could change unfavorably, causing a loss to that spread position. Event Driven Event Driven strategies involve investing in opportunities created by significant transactional events such as spin-offs, mergers and acquisitions, bankruptcies, recapitalizations and share buybacks. Event Driven strategies include Merger and Distressed Securities. Event Driven Equity Strategies opportunistically target companies undergoing a significant corporate transition in the form of a substantive reorganization (distressed or non distressed), spin-off, merger, take-out, recapitalization, asset sale, change of control, dividend change or share buyback. Event Driven Equity strategies can be passive, politely activist, or at times, hostile in nature. One of the key definitional points is that the strategy primarily focuses on the equity portion of the capital structure. Credit Strategies Credit Strategies involve investing in an array of credit oriented securities including: investment grade corporate bonds, high yield debt, bank debt, emerging market bonds, asset backed securities and collateralized debt obligations (CDO s). Investors that trade credit can be long or short depending on their fundamental analysis. All credit instruments are susceptible to default, interest rate and liquidity risks. Convertible Convertible Bond is the purchase of a bond or preferred stock that is convertible into the common stock of the same or a different issuer combined with the simultaneous short selling of the related common stock. The objective of this strategy is to profit from a mispricing of the embedded equity option or credit spread of the convertible security issuer. Convertible arbitrage portfolios may also include asset swaps on convertible securities, credit default swaps, total return swaps and equity options when these instruments offer an improved means of establishing risk-adjusted positions. Identification and exploitation of the market opportunities involve uncertainty. No assurance can be given that investment opportunities will be able to be located or price discrepancies will be correctly exploited. In the event that the perceived mispricings underlying the positions fail to materialize as expected, the positions could incur a loss. Distressed Securities Distressed Securities funds generally invest in securities of financially troubled companies (companies involved in bankruptcies, exchange offers, workouts, financial reorganizations and other special credit-event-related situations). These managers may identify distressed securities in general, or they may focus on one particular segment of the market (e.g., senior secured debt). Investments may be accumulated with a view to an exit via the secondary market, or with the expectation that the company will be recapitalized, restructured or liquidated and the fund manager may either seek to be actively or passively involved in the process. Investments of this type may involve substantial financial and business risks that can result in substantial or, at times, even total losses. In addition, poor information, unclear legal rights and unpredictable pricing and bid/ask spreads may also result in losses. Merger Merger funds take positions in 4

8 companies that are either currently or likely to be engaged in corporate mergers and acquisitions. Merger funds typically buy shares in the company and sell an appropriate quantity of shares in the acquirer in a merger deal. In a completed deal, they will typically have an equal and opposite position in the acquirer, seeking to earn a spread in the meantime. Factors that affect returns include the extent of the spread that can be earned through this transaction, the likelihood of a deal coming to fruition (it may break for regulatory, financial or company-specific reasons) and the likely date of completion of the deal. Finding suitable opportunities may also be difficult during cycles of low merger activity. In addition, merger arbitrage positions are also subject to the risk of overall market movements, which can lead to inadvertent market-related losses. Figure 3 INVESTMENT STYLE RISK/RETURN (January 1990 December 2007) Convertible [1.4] Equity Market Neutral [1.3] Statistical [1.1] Distressed Securities [1.6] Long/Short Equity Emerging [1.3] Market Equity Private Equity [0.8] [0.8] Merger Global Macro [1.2] [1.2] REITs [0.5] U.S. Equity [0.5] 4.00 Fixed Income Global Bonds Global Equity 2 U.S. Bonds [0.4] [0.2] [0.6] [0.8] Source: Hedge Fund Research, Inc. ( HFR ), Venture Economics and PerTrac. Annualized performance statistics based on compounded monthly returns except for Private Equity, which is based on quarterly returns through 06/07 due to lag in reporting. Sharpe Ratio is calculated using the average 3-month LIBOR as the risk free rate. Past performance does not guarantee future results. Real results may vary. When combined with a traditional portfolio of stocks and bonds, hedge funds have the potential to enhance overall portfolio performance due to the possible benefits of diversification. PERFORMANCE & CORRELATIONS OF HEDGE FUND STRATEGIES Opportunities for hedge fund performance returns come from two sources: An expanded universe of securities from which to trade; A wide array of trading strategies implemented without the constraints of regulation common to most traditional products. As a result, hedge funds poparticular risk, return and correlation characteristics that typically do not exist in traditional asset management strategies (see Figures 3 and 4). Volatility and Drawdown Investors should consider a hedge fund s historical levels of volatility and the magnitude of any drawdowns when making investment decisions. The common measure of volatility is the fund s standard deviation. As we have seen in the equity markets over the last several years, an absence of downside volatility over the short term is not a complete indicator of low risk. A fund may have achieved high returns because it was concentrated in sectors favored by the market. However, when those sectors move out of favor, new investors who have subscribed to the fund based on past performance could likely see disappointing returns. The fund s drawdown is often expressed as the percentage loss of a fund s highest value to its lowest value within a specific time period. Funds with high drawdowns may experience a rash of investor redemptions and creditor margin calls. If this is widespread enough, it could handcap a fund manager s ability to maintain proper levels of liquidity. POTENTIAL BENEFITS Adding hedge funds to an investment portfolio may offer several potential benefits. Among the most commonly mentioned are: Volatility Enhanced Risk-Adjusted Return Potential Hedge funds generally have the potential to generate enhanced risk-adjusted returns due to the use of value-added strategies such as leverage and short selling. Diversification When combined with a traditional portfolio of stocks and bonds, hedge funds have the potential to enhance overall portfolio performance due to the possible benefits of diversification. The degree of diversification can vary according to the various hedge fund styles, since different strategies exhibit different historical correlations with the equity and debt markets (See Figure 4). Keep in mind that diversification alone does not eliminate market risks. 5

9 Figure 4 CORRELATIONS OF HEDGE FUND STRATEGIES TO MAJOR U.S. MARKET INDICES (January 1990 December 2007) Equity Long/Short Global Macro Convertible Merger Distressed Securities Equity Market Neutral Statistical Fixed Income: Equity Long/Short Global Macro Convertible Merger Distressed Securities Equity Market Neutral Statistical Fixed Income: S&P Source: HFR and PerTrac as of December Past performance does not guarantee future results. Real results may vary. Investors cannot invest directly in an index. S&P 500 Lehman Aggregate Bond Index Lehman Aggregate Bond Index 1.00 Broad Investment Universe Hedge funds may invest in a wide variety of financial instruments, including stocks, bonds, commodities and currencies. Investors can choose from hedge fund styles that focus on a particular asset class or on other styles that invest across the universe of financial instruments and asset classes. Manager and Investor Interests Are Aligned A hedge fund manager s compensation is closely tied to performance, aligning the manager more closely with the interests of their investors. This being the case, the performance-based fee structures that are characteristic of hedge funds tend to attrasome of the most talented investment managers in the hedge fund industry. However, we should note that the presence of a performance fee might create an incentive for managers to make investments that are more speculative than would be the case in the absence of such performance fees. Where these fees are applicable, they will reduce any annual profits allocated to investors. Hedge funds may trade in esoteric securities, often in illiquid markets. It is sometimes difficult to price these instruments, leading to imprecise market values or fund NAVs. RISKS Although hedge funds may offer such potential benefits as enhanced risk-adjusted returns and diversification, investors should be cognizant of some specific risks, including: Lack of Transparency Since they are inherently less regulated private investment vehicles, hedge funds have not met institutional levels of transparency and accountability. Of course, in recent years, institutional investors and funds of hedge funds have exerted enormous pressure on hedge funds to provide greater transparency. Limited Liquidity Hedge funds are relatively illiquid investments with lockup and liquidity provisions. Most hedge funds specify a lockup period ranging from six months to five years. Typically, an investment cannot be redeemed during this initial period. Leverage (Counterparty Risk) A unique feature of hedge funds is that they have the ability to employ leverage to seek to enhance returns. Hedge funds typically leverage their capital by buying securities on margin or taking out bank loans, and are able to buy derivative products. This avoids having to provide the full capital value at the time of purchase while still gaining market exposure. Since leverage allows managers to borrow and thus invest more than 100% of their assets, it may magnify the potential for loss as well. Moreover, in a serious market crisis, like that in 1998 after the collapse of Long- Term Capital Management, the providers of leverage may decide that they are overextended and call in their credit. A manager receiving this call would have to liquidate its positions, which could result in significant losses. In an even worse scenario, investors in this fund may then decide to redeem their holdings to avoid further NAV declines. 6

10 This can require the fund to liquidate even more positions, potentially causing further declines in its NAV. In the end, the manager may decide that the has no option but to close and return what is left of the investor s capital all because a provider of leverage demanded immediate repayment. Difficulty Accessing Quality Hedge Funds Gaining access to top quality hedge funds can pose a considerable challenge because these managers often reach capacity limits, closing the fund to new investment. Furthermore, the relatively high minimums can make it difficult for small institutions or high net worth individual investors to gain access. Unreliable or Incomplete Return Data Investors may easily determine the value of a security, commodity or futures position, because these instruments are traded on well-regulated exchanges or, as in the case of bonds, through transparent open markets. However, since most hedge funds are private investment vehicles, their managers are able to report their own returns as they choose. In fact, with some of the more illiquid strategies such as distressed debt, the positions cannot be marked to market on a regular basis. Valuation Risk Hedge funds may trade in esoteric securities, often in illiquid markets. In normal markets, it is sometimes difficult to price these instruments, causing managers to estimate market values. In stressed markets, the problem may be compounded, leaving investors with an imprecise Net Asset Value ( NAV ). Asymmetrical Nature of Hedge Fund Return Distributions (Skew) The historical returns for stocks typically exhibit normal distributions, which may be graphed on a bell curve. By contrast, hedge fund strategies typically exhibit asymmetrical distributions that are skewed either positively (e.g., long/short equity and global macro) or negatively (e.g., fixed income arbitrage). Strategies that have historically exhibited negative skew indicate that there is a higher probability of a significant loss taking place. HEDGE FUND STRUCTURES When considering hedge funds, qualified investors have the option of investing in funds managed by single managers or in portfolios containing multiple managers (funds of hedge funds). Single Manager Funds Managers that invest in a single strategy run the majority of today s hedge funds. As a result, they can offer the greatest potetial for return, although they generally carry a higher degree of risk than funds of hedge funds. However, some single manager hedge-funds employ a multi-strategy approach that combines two or more investment strategies such as statistical arbitrage, convertible arbitrage and high yield arbitrage in pursuit of more diversified investments. Funds of Hedge Funds Funds of hedge funds offer investors exposure to a wide range of investment strategies and managers. This creates the potential to provide more consistent absolute returns with the added benefit of diversification. This structure may also provide a more liquid platform than direct hedge fund investments. A fund of hedge funds has the flexibility to over-or underweight certain strategies or managers based on a macroeconomic outlook or quantitative optimization technique. A typical fund of hedge funds may provide exposure to 8 10 different investment strategies by allocating to managers. A fund of hedge funds simplifies the process of choosing a hedge fund because it blends numerous funds to meet a range of investor risk/return objectives, while generally spreading the risk over a variety of funds. In addition, a fund of hedge funds advisor can perform the due diligence and risk monitoring on the individual managers that we believe is critical to a successful hedge fund allocation. Funds of hedge funds tend to have lower investment minimums than single manager funds and are often regarded as the best entry point for private investors interested in hedge funds. However, fund of hedge funds typically charge an additional layer of fees. FEE STRUCTURES Hedge fund managers are typically rewarded in the form of an annual management fee (a pre-defined percentage of net assets) and, more significantly, through a performance-based fee. This is one of the distinguishing features of hedge funds. While annual fees are generally equivalent to 1% 2% of assets, performance fees are typically in the region of 15% 25% of a fund s profits. Hurdle rates (typically 5% per annum) and high watermarks are often enforced to ensure fees are earned for absolute performance. A high water mark is set to ensure that an investor recoups accumulated losses before a performance fee is paid to the manager. This type of fee structure has historically been a standard practice, attracting high-quality investment professionals into the hedge fund sector and encouraging managers to generate maximum returns for investors. As mentioned before, however, the presence of a performance fee might create an incentive for managers to make more speculative investments. CONCLUSION Hedge fund assets are growing dramatically. Some of the top investment professionals in the financial services industry have shifted to managing hedge funds, which have the potential to offer both 7

11 diversification and competitive absolute returns in difficult market environments. One may argue that adding hedge funds to a traditional stock and bond portfolio is a compelling story; however, potential investors should understand that investing in hedge funds is speculative, not suitable for all clients and intended for experienced and sophisticated investors who are willing to bear the high economic risks involved, including the loss of the principal amount invested. Notwithstanding the potential for enhanced returns, the array of hedge fund investment strategies and inherent risks may appear intimidating to the uninitiated. An investor should seek to identify these asset-class-specific risks, isolate them and take steps to mitigate them to the greatest degree practicable. Single managers may focus on one strategy or employ a combination of investment strategies. These funds can offer the greatest potential for growth, although they generally carry a higher degree of risk than funds of hedge funds. Funds of hedge funds can offer lower minimums than single manager funds, which allow broader access to the growing pool of investment talent within the hedge fund industry. Within an actively managed fund of hedge funds, the investment manager conducts due diligence, provides risk monitoring, implements portfolio rebalancing and make stactical asset allocation decisions as market conditions change. The investment manager may also negotiate fee and brokerage arrangements, and typically replaces underperforming advisors and adds capacity as talented advisors close to new investors. When seeking to choose a hedge fund, investors need to be armed with the information necessary to make an informed decision and with an awareness of their own ability to tolerate risk. However, when used properly, a judicious allocation to hedge funds can be an attractive addition to portfolios that seek to achieve favorable risk-adjusted returns. Funds of hedge funds offer investors exposure to a wide range of investment strategies and managers, which has the potential to provide more consistent absolute returns with the added benefit of diversification. HEDGE FUND GLOSSARY A Alpha A mathematical value indicating an investment s excess return relative to a benchmark. It measures an investment s value-added relative to a passive strategy, independent of market movement. B Beta A quantitative measure of the volatility of a stock or strategy relative to a market index. An investment with a beta greater than 1.0 is more volatile than the market, while an investment with a beta less than 1.0 is less volatile than the market. C Capacity The availability of investment opportunity. Capacity issues will have an impact on a manager s ability to effectively employ trading capital. Correlation The measurement of joint movement between two variables. Correlations are measured in a range from 1 to 1. A correlation of -1 implies that the variables move inversely to one another. A correlation of 1 implies that the variables move perfectly in lockstep with one another, but not necessarily by the same degree. A correlation of 0 implies that there is no relationship between the movements of the variables. D Diversification Diversification does not ensure against loss. Drawdown The percentage loss incurred by a fund s highest value to its lowest value (peak to trough) within a specific time period. Duration A measure of interest rate risk that indicates a bond s sensitivity to changes in rates. E Efficient Frontier The set of portfolios of a given population of hedge fund strategies that offers the maximum possible expected return for a given level of risk. Emerging Markets There may be additional risk associated with international investing, including foreign, economic, political, monetary and/or legal factors, changing currency exchange rates, foreign taxes, and differences in financial and accounting standards. These risks may be magnified in emerging markets. International investing may not be for everyone. H High-Water Mark The maximum level of profits a fund has previously achieved, which must be exceeded before additional performance fees can be charged. For example, if a fund makes $100 in the first quarter and $100 in the second quarter, but loses $100 in both the third and fourth quarters, the fund must make back (and exceed) the initial $200 before the advisor is eligible to charge a performance fee again. Hurdle Rate The minimum return an hedge fund investment advisor must achieve before a performance fee is paid. It is often expressed as a chosen base rate (e.g., LIBOR or U.S. Treasury Bill rate) or as a spread above a base rate. L Leverage Refers to the use of various financial instruments, including credit lines and options, to attempt to enhance returns but at a higher level of risk. Leverage has the effect of magnifying both positive and negative results. LIBOR The London Inter-Bank Offered Rate, which is the rate that the most credit worthy international banks dealing in Eurodollars charge each other for loans. M Market Risk The risk that the value of 8

12 securities, commodities and currencies may fluctuate due to a variety of factors, including changes in investor outlook, as well as political and economic environments. N Net Asset Value (NAV) The current value of a fund s assets, less its liabilities. O Optimization A mathematical process that seeks to maximize expected portfolio return for a targeted level of risk, or minimize expected risk for a targeted level of return, generally based on forecasts or historical parameters. S Sharpe Ratio A measure of risk-adjusted return. It is calculated by dividing the investment s return less the risk-free rate of return (typically, 3-month Treasury bills or LIBOR) by the investment s standard deviation. An investment with a higher Sharpe Ratio has a better risk-adjusted return compared with an investment with a lower Sharpe Ratio, assuming returns follow a normal distribution. Standard Deviation (Volatility) Standard deviation of an investment portfolio measures the variation of returns around the portfolio s mean return. It is the most widely used approximation for risk. An investment with a higher standard deviation is generally considered riskier than an investment with a lower standard deviation. Strategy Risk The risk that investing strategies, as market conditions change over time, may be out of market favor for considerable periods, with adverse consequences for investor portfolios. T Transparency Risk The risk associated with the common hedge fund practice of releasing only limited information about portfolio holdings. It is a consistent issue with hedge fund advisors because of their unregulated nature. For a more comprehensive glossary, please refer to the Hedge Fund Glossary from Citigroup Alternative Investments or your investment professional. IMPORTANT INFORMATION The opinions expressed herein or in a Fund s offering documents may differ from opinions expressed by Citigroup or any of its affiliates or businesses, and are not intended to be a forecast of future events or a guarantee of future results. See Certain Risk Factors in the respective Confidential Memorandum. This document is offered for informational purposes only and does not constitute an offer to sell any securities. An offer or solicitation will be made only through the applicable Confidential Memorandum and Subscription Agreement, and is qualified in its entirety by the terms and conditions contained in such documents. Each Confidential Memorandum contains additional information needed to evaluate the investment and provides important disclosures regarding risks, fees and expenses. Before making an investment, potential investors should carefully read the applicable Confidential Memorandum and Subscription Agreement and consult their professional advisor. You may obtain a copy of a fund s Confidential Memorandum and Subscription Agreement from your professional advisor. The third-party information contained herein has been obtained from various published and unpublished sources considered to be reliable. However, Citigroup Inc. and its affiliates and subsidiaries ("Citigroup") cannot guarantee its accuracy or completeness and thus do not accept liability for any direct or consequential losses arising from its use. In addition, Citigroup can accept no responsibility for the tax treatment of any investment product, whether or not the investment is purchased by a trust or company administered by an affiliate or subsidiary of Citigroup. Citigroup assumes that, before making any commitment to invest, the potential Investor (and where applicable, its beneficial owners) has received whatever tax, legal or other advice the potential Investor/beneficial owners considers necessary and has arranged to account for any tax lawfully due on the income or gains arising from any investment product provided by Citigroup. At any time, Citigroup or its employees, agents or representatives may have a position, subject to change, in any securities or instruments referred to, or provide services to H E D G E F U N D S the issuers of those securities or instruments. Tax Disclosure (IRS Circular 230): Citigroup Inc., Its affiliates, and its employees are not in the business of providing tax or legal advice. These materials and any tax-related statements are not intended or written to be used, and can t be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Taxrelated statements, if any, may have been written in connection with the promotion or marketing of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. Diversification does not ensure against loss. There may be additional risk associated with international investing, including foreign, economic, political, monetary and/or legal factors, changing currency exchange rates, foreign taxes, and differences in financial and accounting standards. These risks may be magnified in emerging markets. International investing may not be for everyone. Unless you are otherwise advised in writing, Smith Barney is acting as a broker-dealer and not as an investment adviser. When used wisely, borrowing can be beneficial to your total wealth management. 9

13 Depending on your state of residency, some bonds may be exempt from state and local taxes; however, interest may be subject to the federal alternative minimum tax. Preferred securities can be called prior to maturity, which may reduce yield if purchased at a premium. Preferred securities may be subject to other call features or corporate restrictions that may have an effect similar to a call. Prices may fluctuate reflecting market interest rates and the issuer s credit status. There is no guarantee that these strategies will succeed. This information is intended to illustrate products and services available at Smith Barney. The strategies do not necessarily represent the experience of other clients, nor do they indicate future performance. Investment results may vary. The investment strategies presented are not appropriate for every investor. Individual clients should review with their Financial Advisors the terms and conditions and risks involved with specific products or services. Past performance is no guarantee of future results. Non-Confidentiality. A potential Investor (and each employee, representative, or other agent of the Investor) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of a CAI advised fund and the transaction and all materials of any kind (including opinions or tax analyses) that are provided to the potential Investor relating to such tax treatment and tax structure.u.s. Tax-Reporting. Investors who are required to file a U.S. federal tax return may be required to file an additional form with their return and a copy with the Internal Revenue Service. Non-US Legal Considerations. Investors who are residents of countries other than the U.S. should consult their legal and tax advisors concerning the regulatory and tax implications of an investment prior to making an investment decision. Citigroup Alternative Investments LLC ("CAI") is not acting as the advisor or agent for clients purchasing shares or units, and thus clients cannot rely on CAI in connection with their decision to make an investment. This document is being presented to clients based on the understanding that each client has sufficient knowledge, experience and professional advice to make its own evaluation of the merits and risks of any investment. Except as provided above under "Non-Confidentiality", this information is confidential and intended solely for the use by CAI and its affiliates with its clients and their advisers. It is not to be reproduced or distributed except with the permission of CAI. "The Citigroup Private Bank" is a business of Citigroup, which provides private banking clients access to a broad array of products and services available through bank and non-bank affiliates. Not all products and services are provided by all affiliates or are available in all locations, and not all investments are suitable for all investors. Citigroup Private Bank Relationship Managers and Private Bankers in the U.S. Region are registered representatives of Citigroup Global Market & Inc., member NASD/SIPC, an affiliate of Citigroup and a federal Registered Investment Adviser. In the United Kingdom, this document is communicated and approved by Citibank, N.A. (London branch) and Citibank International plc, 33 Canada Square, Canary Wharf, London E14 5LB, each of which is authorized and regulated by the Financial Services Authority, and if their investors have any doubt about the suitability of this investment, they should contact their respective representatives in the U.K. for advice. This document is communicated by Citibank International plc in all other EU Member countries. Citibank N.A. and Citibank International plc are registered with the Netherlands Authority for the Financial Markets. Smith Barney is a division of Citigroup Global Markets Inc., member NASD/SIPC, an affiliate of Citigroup and a federal Registered Investment Advisor. Clients of Smith Barney should contact their Financial Advisor if they have any questions about the investments described in this document. No person has been authorized to make representations or provide any information relating to these investments which are inconsistent with or not otherwise contained in the respective Confidential Memorandum. This document is communicated by Citibank International plc in the EU and U.K. Citibank International plc is registtered with the Netherlands Authority for the Financial Markets. As further described in the offering documents, an investment in alternative investments can be highly illiquid, are speculative and not suitable for all investors. Investing in alternative investments is only intended for experienced and sophisticated investors who are willing to bear the high economic risks associated with such an investment. Investors should carefully review and consider potential risks before investing. Certain of these risks may include: - loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices; - lack of liquidity in that there may be no secondary market for the fund and none is expected to develop; - volatility of returns; - restrictions on transferring interests in the Fund; - potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized; - absence of information regarding valuations and pricing; - complex tax structures and delays in tax reporting; - less regulation and higher fees than mutual funds; and advisor risk. Individual funds will have specific risks related to their investment programs that will vary from fund to fund. Actual results may vary and past performance is no guarantee of future results. Citigroup Global Markets Inc. Member SIPC.Securities are offered through Citigroup Global Markets Inc. Smith Barney is a division and service mark of Citigroup Global Markets Inc. and its affiliates and is used and registered throughout the world. Citi and Citi with Arc Design are trademarks and service marks of Citigroup Inc. and are used and registered throughout the world. Citigroup Global Markets Inc. and Citibank are affiliated companies under the common control of Citigroup Inc. OPINIONS EXPRESSED IN THIS DOCU- MENT ARE INTENDED SOLELY AS GENER- AL MARKET COMMENTARY AND DO NOT CONSTITUTE INVESTMENT ADVICE OR A GUARANTEE OF RETURNS. AI Copyright 2008 Citigroup Inc. All Rights Reserved.