The Difficulty with Portable Alpha: Finding the Alpha

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1 The Difficulty with Portable Alpha: Finding the Alpha Dave Tsujimoto Director, Alternative Investments Russell Investment Group Important Information Copyright 2006 Russell Investment Group. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investment Management. It is delivered on an as is basis without warranty. This presentation is issued by Russell Investment Management Pty Ltd ABN , AFS Licence It provides general information only. It has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been complied from sources considered to be reliable, but is not guaranteed. Russell Investment Group is a registered trade name of Frank Russell Company, a Washington U.S.A. corporation, which operates through subsidiaries worldwide, including Russell Investment Management. Frank Russell Company is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Investment Group is the owner of the trademarks, service marks, and copyrights related to its respective indexes. The Russell logo is a trademark and service mark of Frank Russell Company. Unless otherwise noted, the source for the data in this presentation is Frank Russell Company. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. In general, alternative investments involve a high degree of risk, including potential loss of principal; can be highly illiquid and can charge higher fees than other investments. Hedge strategies and private equity investments are not subject to the same regulatory requirements as registered investment products. Hedge strategies often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. Specific sector investing such as real estate can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes and tax laws and interest rates all present potential risks to real estate investments. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. Date of first use: November, 2006 THIS CONFERENCE MATERIAL WAS CREATED BY RUSSELL AS AN EDUCATIONAL TOOL, AND NOT INTENDED FOR FURTHER DISTRIBUTION.

2 Hedge Funds and Active Management Why Do We Hire Active Managers? Alpha: excess return after adjusting for market risk In aggregate, alpha is zero and is negative after subtracting manager fees

3 Sources of Return Index Fund Traditional Fund Directional Hedge Fund Non-Directional Hedge Fund Beta Manager Skill (Alpha) Hedge funds offer higher alpha potential Source: HFR Industry Reports, HFR, Inc., April 2006, Russell Investment Group For illustrative purposes only. Aren t Hedge Fund Fees Too High? Hedge Funds Alpha Potential Long Only Funds Index Funds Total Fees Hedge funds fees are often in line with their alpha potential Exhibit used for illustrative purposes only and not meant to represent any actual investment.

4 Hedge Fund Returns Hedge Fund Returns Have Been Coming Down Annualized Returns HFRI Fund of Funds Composite Index 12% Annualized Rate of Return 1 8% 6% 4% 2% Are Hedge Fund Investment Opportunities Disappearing? Source: Hedge Fund Research, Inc. HFR, Inc.

5 Why Have Returns Declined? 1 Nondirectional Strategies 4 Nondirectional Strategies 9 Directional Strategies 6 Directional Strategies Lower equity market returns negatively impact directional strategies 2 Increase in lower risk, lower return, non-directional strategies Institutions tend to favor non-directional strategies and often utilize them in portable alpha mandates Source: Hedge Fund Research, Inc. HFR, Inc., Russell Investment Group Hedge Fund Returns Remain High on a Risk Adjusted Basis 12% HFRI Fund of Funds Composite Index 6% Annualized Rate of Return 1 8% 6% 4% 2% 5% 4% 3% 2% 1% Alpha Return Standard Deviation Alpha Market Proxy: MSCI World, Risk Free Rate: CG T-Bill 3 Month Source: Hedge Fund Research, Inc. HFR, Inc., Mellon Analytical Solutions. Periods ending December 31, Based upon preliminary results. Indexes shown are for comparative purposes only and are not meant to represent any actual fund performance. Indexes are unmanaged and cannot be invested in directly.

6 Increasingly Efficient Markets The Hedge Fund Industry Has Experienced Rapid Growth Industry assets now exceed US$ 1.2 trillion and are increasingly being driven by institutional allocations 1,400,000 AUM ($ in Millions) 1,200,000 1,000, , , , ,000 0 It is estimated that there are now nearly 9,000 hedge funds globally Source: Hedge Fund Research, Inc. HFR, Inc Q2 2006

7 Excessive Capital Chasing Diminishing Opportunities $50,000 Convertible Arbitrage 16. $45, Strategy AUM ($millions) $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10, Annual % Return $5, $ Cvt Arb Asset Flows Cvt Arb Annual Return 0. Source: Hedge Fund Research Inc. For Russell Associate Use Only. Not For Public Distribution. Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. Hedge Funds May be Taking Alpha from Long Only Investors $1,600 2 Assets Under Management ($ in Billions) $1,400 $1,200 $1,000 $800 $600 $400 $200 15% 1 5% Excess Rate of Return $ HF AUM LO Sm. Cap Growth Mean Excess Rate of Return (%) HF AUM Exponential Trend Line This results in more efficient markets for all market participants Sources: Russell, Hedge Fund Research, Inc HFR, Inc. Excess Returns: 3 Year Rolling Small Cap Growth Equity Accounts Universe Means in Excess of Russell 2000 Growth Index

8 Evolving Sources of Alpha Increasing Opportunities Outside of U.S. Markets 35% Estimated Share of Global Hedge Fund AUM % 2 15% 1 5% Europe Asia Estimated $19 billion in Latin American hedge funds 2 Nearly 100 hedge funds in South Africa 1. Russell estimates based on data from Hedge Fund Research, Inc. HFR, Inc., Hedgefund Intelligence, Hedgeweek 2. TABB Group

9 Hedge Funds as Catalysts Activist Hedge Funds Primarily long-only, deep value investors Large stakes in company stock and concentrated portfolios Hedge funds act as catalyst for price appreciation Attractive Historical Performance Annualized Return, 5 Years Ending July 31, 2006 Activist Universe* 21.7% Russell 3000 Index 3.9% *Based on Median Performance of Russell s proprietary research universe of activist equity managers Hedge Funds As Catalysts Financing Strategies # Banks 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 US Banking Trends: $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 $ Bln Number of Banks Total Assets Asset-based lending strategies make collateralized loans to middle-market companies PIPE strategies invest in private placement securities of publicly traded companies Source: FDIC Source: FDIC

10 Keys To Capturing Hedge Fund Alpha in the Future Avoid selecting funds & strategies based on past performance Be willing to be contrarian Search for opportunities globally across multiple asset classes Seek out new and niche strategies, getting in before the crowd Pay attention to hedge fund operational risks Keep an eye on the traditional money managers Don t be afraid of individual manager volatility Have your own hedging capabilities Pursue custom mandates with hedge funds Diversify