Absolute Return Strategies

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1 R E P R I N T E D F R O M n o v e m b e r 1 9, Absolute Return Strategies William E. Flaig Jr., Chief Investment Officer at Arrow Investment Advisors, LLC, joined the firm in February He spent five years at Rydex Investments, working as Director of Portfolio Management, in which he managed the entire portfolio team. While at Rydex, Mr. Flaig defined the concept of hedge fund replication, initiated the research and investment strategies on which the Rydex Absolute Return Strategies Fund and the Rydex Hedge Equity Fund are based, and directed those strategies. He also developed best practices for creating leverage within the constraints of a mutual fund offering unlimited trading. Prior to Rydex, he spent six years at Bankers Trust Company in a range of roles including currency trading, proprietary trading, derivatives structuring, emerging market fixed-income, and currency trading. He graduated from Purdue University with a degree in Management. TWST: Please start with an overview of Arrow Funds. Tell us all about its investment philosophy and what you do there. Mr. Flaig: Arrow Funds is one of the fasting growing investment management companies in the industry. The company was formed in early 2006 and launched its first product, the Arrow DWA Balanced Fund, in August of that year. We ve had great success with that product it exceeded $100 million in AUM right after its one-year anniversary. Over the last year, the Fund has continued to outperform 90% of the funds in the Morningstar moderate asset allocation category. Arrow s vision is to manufacture and distribute alternative investment solutions for financial intermediaries and their clients. The Arrow founders are made up of the original product development team at Rydex Investments. They worked together for a number of years as a team, developing and distributing mutual funds, ETFs, variable trust funds and WRAP programs. The business lines and products they created were instrumental components to the recent sale of Rydex. I met this team when I was the Director of Portfolio Management at Rydex. I joined Arrow Funds earlier this year, in the capacity of Chief Investment Officer, with a mandate to enhance the firm s manufacturing capability of absolute return strategies and oversee other investment initiatives. Absolute return strategies aim to produce positive returns in as many environments as possible. In a declining market, successfully implemented absolute return strategies aspire to provide positive returns, or to avoid or hedge market risk. To this end, absolute return strategies may use hedging, short selling, or for arbitrage or other positions less dependent on broad market direction. In a declining market, a relative return strategy, which is designed to track an index, will track the index down the manager, who typically has a mandate to stay invested, hopes to marginally outperform on the downside. Conversely, in a rising market, the relative return manager benefits from the rising tide of its asset class. The manager may or may not participate in such a rise, depending on whether M O N E Y M A N A G E R I N T E R V I E W

2 MONEY MANAGER INTERVIEW absolute return strategies his strategy is correlated to or hedged against the rising asset class, and whether or not the sources of the absolute return strategy s returns and risk are related to that asset class. Absolute and relative returns are different from each other and widely varied among themselves. Stock and bond funds, while both relative return strategies, are as different from each other as long/short equity are from fixed income arbitrage among absolute return strategies. We plan to deliver 1940 Act products that make use of these differences. By doing so, we will provide mutual fund investors with an array of tools comparable to that available to institutional investors. We would love to put the mutual funds on a more equal footing with endowments by providing similar product objectives and nontraditional sources for returns, greater opportunities for diversification and tools for risk management. Our first absolute return strategy vehicle is called the Arrow Alternative Solutions Fund. TWST: Tell us about some of these alternative investment strategies that you brought to the firm and how that ties in with the Aternative Solutions Fund. Mr. Flaig: I will speak to my background a little bit before I go into that. Prior to working at Rydex, I had extensive experience at Bankers Trust with investment strategies and assets that ran the gamut from fixed income, equities, global fixed income, and currencies to derivatives trading and structuring. This helped me acquire insight and expertise into the instruments used in alternative strategies. My experience at Rydex, which is primarily an equity indexing shop that uses derivatives extensively, afforded the opportunity to hone the practical application of these instruments for mutual funds. As the Director of Portfolio at Rydex, I was responsible for the management of $10 billion spread over several unique investment strategies. I was significantly involved in building and then refining the firm s quantitative investment process. Also, I extensively researched and developed the concept and framework for Rydex s hedge fund replication strategies. I left Rydex to research and develop a better alternative value proposition. While the roots of my replication research helped, I ve spent the last 18 months developing another alternative approach. The Arrow Alternative Solution Fund is a major step forward because it combines some of the principles of hedge fund replication with modern portfolio theory. At Arrow, I ve developed several absolute return factors, which go beyond traditional investment methodologies because they attempt to reduce correlation to the risk of a given asset class. Whether or not to favor relative return factors or absolute return factors, and how to apply those factors, are questions strongly influenced by the efficient market debate. I believe that the bulk of traditional returns are driven by exposure to relative The Fund s principle investment strategy seeks to maximize returns from a diversified portfolio of three long and short strategies with a targeted risk objective. We are looking to achieve a total rate of return that meets or exceeds 10% per year after management fees over a rolling three- to fiveyear time horizon, with a risk target of 7% as measured by annual standard deviation, and a beta to the S&P 500 of less than 0.5. return factors. Because a relative return factor behaves with high correlation to and within its asset class, it has no mechanism to control downside risk during cyclical negative market periods. Therefore, relative return factors contain market risk. Traditionally, investors have attempted to mitigate the risk inherent in relative return factors by creating diversified portfolios, which may allocate between stocks and bonds, between domestic and international stocks, between growth and value stocks, or between stocks of different capitalization ranges and different sectors. I believe that the ultimate goal of diversification to combine assets that move independently of one another has not been satisfactorily achieved by traditional approaches. My approach combines these absolute return factors to create a core alternative portfolio. This kind of portfolio construction is optimal for seeking absolute returns and capital appreciation with low volatility and low correlation to the equity markets.

3 MONEY MANAGER INTERVIEW absolute return strategies The Fund s principle investment strategy seeks to maximize returns from a diversified portfolio of three long and short strategies with a targeted risk objective. We are looking to achieve a total rate of return that meets or exceeds 10% per year after management fees over a rolling three- to five-year time horizon, with a risk target of 7% as measured by annual standard deviation, and a beta to the S&P 500 of less than 0.5. As with any fund, let me state that we do not represent or guarantee that the Fund will meet these goals. This orientation has proven costly, especially since The future demands a more varied investment approach in order to preserve and enhance capital for a generation of investors. The Arrow Alternative Solutions Fund seeks to combine the best features of hedge funds and mutual funds. Some of the shared characteristics compared would be that hedge funds and long/short mutual funds are both seeking absolute returns that is, positive returns regardless of the market environment while traditional mutual funds are generally just seeking returns relative The Arrow Alternative Solutions Fund is a mutual fund structure with hedge fund features. Hedge funds have long been highly regarded for their use of alternate strategies and investment techniques. However, the structure of the hedge funds themselves often raises concerns for investors. Historically, the mutual fund industry has been oriented to long-only investing. This orientation has proven costly, especially since The future demands a more varied investment approach in order to preserve and enhance capital for a generation of investors. TWST: The Alternative Solutions Fund seems to combine features of mutual funds and hedge funds. Is that correct and, if so, what are the differences? Mr. Flaig: You re correct, the Fund does combine features of mutual funds and hedge funds. The markets are a catalyst for change and so is market regulation. The mutual fund industry is always looking for way to preserve its own income stream as well as investor capital. Their foray into the hedge fund space started in 1997 when Congress repealed the mutual fund shortshort rule. Congress believed it would be in the public interest if mutual funds could trade (and hedge) more broadly and effectively. Rydex delivered the first inverse strategies that were tied to indices like the S&P 500. These funds became great hedging tools for the tactically proficient investor. Other manufacturers created dedicated long/short strategies and now some are utilizing strategies designed to mirror the performance of hedge fund indices. More specifically, the Arrow Alternative Solutions Fund is a mutual fund structure with hedge fund features. Hedge funds have long been highly regarded for their use of alternative strategies and investment techniques. However, the structure of the hedge funds themselves often raises concerns for investors. Historically, the mutual fund industry has been oriented to long-only investing. to benchmarks that have periods of outperformance and underperformance. Traditional mutual funds typically have high correlations to equity and bond markets while the Arrow Alternative Solutions Fund and hedge funds have low correlations to equities and the bond market. Mutual funds are highly regulated with oversight from the SEC, while hedge funds operate in an environment with far less regulation. Mutual funds have restrictions on leverage, illiquid securities, and derivatives; limitations on incentive fees; and protective custody requirements. These restrictions keep some of the problems found in the hedge fund away. Mutual funds are highly transparent and they offer liquidity through the daily NAV. Most hedge funds pride themselves on not being transparent and they limit the frequency of investor redemptions. Another major difference is the structure of managers compensation. Mutual fund companies charge fees from 1% to 4.5% on the amount of assets under management, regardless of performance (in the case of the Arrow Alternative Solutions Fund, the fee is 1.52%). Most hedge fund companies charge flat management fees of 1% to 2% based on the total assets under management plus 20% to 25% incentive fees. Aside from the hedge funds high fees and lack of oversight, the next biggest barriers to purchase are investor qualifications and high minimums.

4 MONEY MANAGER INTERVIEW absolute return strategies Hedge funds are restricted to accredited investors and they typically have investment minimum that range between $100,000 to $1,000,000. Mutual funds are open to all investors. While most funds do have minimums, these minimums range between $1,000 and $10,000. Our Fund s non-qualified minimum is $5,000 and $2,000 for retirement accounts. equity strategy will provide exposure to eight absolute return factors (e.g. long/short value). The Fund could have between 40% and 60% exposure to this strategy. The fixed income arbitrage strategy seeks to generate returns from relationships between different fixed income securities, employing long and short positions to minimize exposure to The Alternative Solutions Fund provides exposure to three long/short strategies, including hedged equities, fixed income arbitrage and managed futures. The goal of each long/short strategy is to systematically identify and provide exposure to absolute return factors on an ongoing basis. The hedged equity strategy seeks to generate returns from investing on both the long and short sides of equity markets while maintaining a low correlation to the US equity market. Offering a more diversified and robust portfolio that can preserve and enhance capital over time in all market environments is something that only a very few have had access to in the past. The Arrow Alternative Solutions Fund was designed so that all investors can have access to a low cost, highly diversified absolute return strategy. It s indeed the best of both worlds. TWST: Tell us about the allocation of your different strategies and the composition of the Fund? Mr. Flaig: The Arrow Alternative Solutions Fund provides exposure to three long/short strategies, including hedged equities, fixed income arbitrage and managed futures. The goal of each long/short strategy is to systematically identify and provide exposure to absolute return factors on an ongoing basis. The hedged equity strategy seeks to generate returns from investing on both the long and short sides of equity markets while maintaining a low correlation to the US equity market. The hedged Absolute Return Factors for each Strategy interest rate changes that are either mathematically or historically interrelated. The strategy will provide exposure to five absolute return factors (e.g. high yield credit spread). The Fund could have between 20% and 45% exposure to this strategy. The managed futures strategy seeks to generate returns from convergent and divergent trends in the commodity, financial and currency futures markets. The Fund could have between 20% and 30% exposure to this strategy. The managed futuresstrategy will provide exposure to four absolute return factors (e.g. long/ short commodity sector relative strength). The allocation among the strategies is determined with a portfolio optimization tool to maintain targeted risk of 7%. The Fund has several long/short portfolios but there is ultimately an underlying investment rationale that supports why the absolute return factor has historically had positive performance and why we would expect that performance to continue in the future. I speak to this in a white paper that we ve developed, and each investment rationale is supported by industry practice and academic research. TWST: Do the three long/short investment strategies, your three buckets, all include the absolute return factors you mentioned previously?

5 M O NMONEY E Y M AMANAGER N A G E R INTERVIEW I N T E R V I E W absolute i n v return e s t i g strategies i n s t o c k s Mr. Flaig: They do. Since absolute return factors are being pioneered by Arrow Funds and it s not a widely publicized concept, I think it would be helpful to explain what they are. Absolute return factors go beyond traditional investment methodologies in an attempt to reduce correlation to the risk of their asset class. The objective is to deliver the return of a particular investment style, while reducing that style s overall and market risk, thus reducing portfolio volatility over time. We use a quantitative methodology to identify two subsets within each absolute return factor: those assets expected to outperform the asset class, which are held long; and, those expected to underperform the asset class, which are sold short. This long/short portfolio construction attempts to minimize the risk of substantial losses stemming from market declines while reducing volatility. Each absolute return factor is tied to a very common hedge fund strategy. The long/short value is an absolute return factor in the Fund s hedged equity strategy. I use this as an illustration because almost all investors have a value exposure in their portfolio. Another very commonly held exposure in portfolios is size. This is based on research done by many, but particularly Fama and French, who validated the idea that value and small companies historically outperformed the marketplace. The rationale for why they outperformed the overall market is that an investor is taking more risk in a value company or a small cap company. The investor is compensated for this greater risk with a greater return, so risk reward supports why investors, from an academic standpoint, include value in their portfolios and why investors include small cap in their portfolios. Since the early 1990s, this has been a generally accepted investment philosophy and people have been allocating to these styles accordingly. That s the starting point for an absolute return factor, but when an investor buys value or buys small cap he is also just getting equity market risk or equity risk premium as well in his investment. You will still have years where even a value holding or a small cap holding will lose money if the overall equity market is down. The return is always going to be relative to that equity risk premium and if you look at the correlation to the S&P 500, value and size investing is high higher than 0.8 and very likely higher than 0.9. The Fund s long/short portfolio construction and the absolute return factor philosophy are applied to a value basket. The absolute return factor that provides exposure to value will buy value stocks just like traditional investors but we simultaneously purchase a portfolio of non-value stocks against the long basket. What is produced is the absolute return of value and not the relative return of value. By doing that, we are reducing the The managed futures strategy seeks to generate returns from convergent and divergent trends in the commodity, financial and currency futures markets. The Fund could have between 20% and 30% exposure to this strategy. The managed futures strategy will provide exposure to four absolute return factors (e.g. long/short commodity sector relative strength). The allocation among the strategies is determined with a portfolio optimization tool to maintain targeted risk of 7%. equity exposure, emphasizing the value exposure in a more pure way. This is the simple building block behind the Fund s absolute return factors. This long/short portfolio construction is applied to many of the same traditional investment styles that are used by investors today. The Fund will be long a broad mix of financial asset classes, including equities, fixed income, currencies and commodities. The Fund will be short the same broad mix of financial asset classes using derivatives. Most long/short strategies focus on one or multiple absolute return factors. Some focus on just equities, fixed income or commodities. The individual exposures are rarely combined. However, hedge fund of funds strategies will combine them. How they are combined is their downfall. Isolating those traditional investment styles into a corresponding absolute return factor is critical to our approach. Our value proposition is how we combine these factors.

6 M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E W absolute i n vreturn e s t i n g strategies i n s t o c k s TWST: How are you able to get a performance record for such diverse strategies? What is the comparison you use to measure performance? Mr. Flaig: I spent the last 18 months testing each absolute return factor. I have elaborated on this in a white paper. In the paper, we use only third-party data to be able to test the strategy both historically and transparently. Because of data quality, we limited the overall backtest, but I have personally tested equity absolute return back to There are obvious data limitations on the fixed income and commodity data set for our testing, but we backtested the Fund s strategy with thirdparty data back to Because there are practical limits that come with third-party data, we produced our own proprietary historical return stream for each absolute return factor. This data set was created to help our implementation and management of the Arrow Alternative Solutions Fund. We are also happy to report that the conclusions were essentially the same when we compared the two data sets. What we ve created is very exciting. The Arrow Alternative Strategy was tested back to 1995 has offered an annual return of 14% with a risk of about 6%. This is an excellent risk-adjusted Historical Look at the Arrow Alternative Strategy return when compared to traditional assets. The beta to the S&P 500 over that time period was about a 0.13, and a.46 Sharpe ratio. What was really telling was how the strategy performed over the worst and best three year period since Between April 2000 and March 2003 the S&P 500 lost an annualized 16.1% with a standard deviation of more than 17%. During that time period, the alternative strategy was up about 13%, again, with a 6.3% standard deviation. Between April 2003 and March 2006 the S&P 500 was up 17% annualized with a standard deviation of 8.8%. During that time period, the alternative strategy was close to 13%, again, with a 6.5% standard deviation. While the S&P 500 was nearly flat over the combined period, the Arrow Alternative Strategy annualized return was more than 12% and less risk and very little correlation. In an environment when the S&P 500 is doing very well or an environment when the S&P 500 is doing poorly, this Fund s backtested performance has been stable. We ve seen strong returns with a very controlled level of risk and a low beta to the S&P 500. So from a big picture perspective, if you think of a portfolio as the efficient frontier as we ve all been taught, adding this strategy to a portfolio bumps the efficient frontier out to what s commonly called the northwest quadrant: more return for either the same or less risk to the positive attribute. If you look at it over a complete market cycle, in years when traditional investments are struggling, this strategy is performing extremely well, and in years when the S&P or bonds are strong, this strategy is also keeping up it s still on the efficient frontier. From the diversification standpoint, you are getting strong performance and diversification in bear markets, which is when you need it most, and the cost of doing it is minimal because it s still on the efficient frontier in strong market environments.

7 M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E W absolute i n vreturn e s t i n g strategies i n s t o c k s TWST: Are there any other risk management techniques that you incorporate into the strategies that you can tell us about? Mr. Flaig: I would like to keep that simple. In our optimization approach, we are targeting a fixed level of risk as opposed to an asset-based target. That s an extremely strong value proposition. We do have diversification constraints in place to prevent the Fund from piling into one strategy at any given time. We also have the risk constraint: for an absolute return strategy even to be considered in the Fund, it has to have a compelling historical risk towards justification supported by research beyond our own institution with a strong enough investment rationale that would convince us that the strategy s compelling performance would continue in the future. We have several additional risk controls that are inherent to mutual funds themselves. Also, from a portfolio construction standpoint, think of the extent that a long/short strategy is leveraged. We are buying long exposure that s greater than the Fund s assets and we re creating short exposure, which is also significant. The level of that overall exposure is constrained so that we can t get runaway leverage and the amount of net exposure, which is the long minus the short exposure, has to be below 0.8 as well. The Fund has to be long/short and not overly leveraged these risk controls are laid out in the Fund s prospectus. As mentioned earlier, alternative strategies have posted strong returns with lower volatility than their stock and bond coun- Risk Band for Various Market Indicators terparts. But to round out that picture, it s necessary to consider that volatility is not the only measure of risk a client could face. Volatility takes into account what normally happens, but it doesn t reflect just how far outside the normal distribution the returns can be. For that we looked at the risk band that is, the peak, median and low. The alternative strategy does a satisfactory job of achieving its 7% risk objective when we evaluated the rolling three-year average from January 1995 though September The risk band is narrower than the equity market and most of the hedge fund proxies that we put it against. Looking at the 36- month rolling standard deviation and return, we discovered what you would expect for the S&P 500. The S&P 500 risk band ranged between 7.6% and 22.2% with average risk of 16.7% and average return of 10.9%. When compared to credit Suisse Tremont Hedge Fund Index, the risk band was smaller 3.1% to 12.9% but it had lower average risk of 8.4% and slightly lower returns of 10.3%. However, the risk band for the alternative strategy was tighter and similar to a bond portfolio (between 6% and 7.6% with an average risk of 7.1% and a 13.3% return). This was higher than both. The Credit Suisse Tremont Hedge Fund Index performance was in line with our strategy but its risk band resembled the equity markets it had a beta of.50 and risk average of 10.3%, similar to a traditional 60% equity and 40% bond portfolio. The average beta for the alternative strategy was TWST: What gives this Alternative Solutions Fund its edge? What are the defining features that you think makes it distinctive compared with other alternative strategies at other firms? Mr. Flaig: The diversification across multiple hedge fund strategies and the specific risk target of 7% are competitive advantages. The Fund is combining three systematic long/short strategies is also an advantage over black-box type construction methodologies used by others. Lastly, the fund is not backward looking that is, looking at what hedge fund indexes or hedge fund holdings have been. It is only forward-looking in its portfolio construction.

8 M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E W absolute i n vreturn e s t i n g strategies i n s t o c k s Long / Short Portfolio Exposure If I compare those advantages to groups of other alternative products in the marketplace, the Arrow Alternative Solutions Fund has better diversification and better risk controls than funds that are offering hedge fund replication (that is, a high correlation to hedge fund indexes); additionally, it is not a black box and is not looking backward at hedge fund indexes. When I look at this fund versus hedge funds of funds or mutual funds that invest in hedge fund subaccounts, the Arrow Alternative Solutions Fund has superior diversification and risk controls. We also do not have manager risk or capacity constraints that might exist in some of those funds. Many of those funds are allocating to small hedge fund managers, a process that does not have scalability. This is because as hedge fund managers get bigger, their performance tends to deteriorate. Not unlike in the mutual fund space, the niche is somewhat dependent upon liquidity and small size to be able to deliver that value proposition. The Arrow Alternative Solutions Fund may not have scalability problems, so it will not have limits as to how much it can grow without a deterioration of performance. And lastly, against long/short strategies that are proliferating in the marketplace, most of them are not diversified; they are actually narrowly focused on a particular investment style. They don t have diversification, they have manager risks, and a lot them are focusing on what I would call the, , type of long/short portfolio construction, which is very different from the portfolio construction used in this Fund. You should note that a lot of these funds struggled in the volatile market over the summer of In portfolio construction, the manager buys $1.20 of long exposure for every dollar of investor money and creates the 0.2 short exposure. This structure gives the manager leverage to beat a benchmark, but it does not lower portfolio s correlation to the S&P 500. The portfolio s 120% long exposure minus 20% short exposure has 100% net long exposure, which is why its correlation to the S&P 500 is higher. Our fund s portfolio net exposure will not be 100% net long. In fact, historically the strategy will have $1.50 of long exposure and $1 of short exposure 150% long exposure minus 100% short exposure has 50% net exposure. That is half of the overall market exposure. The net exposure will range between 50% and 80%, which is driven by our optimization process. Tools that provide lower correlation to the traditional equity market are better vehicles to diversify traditional portfolios. Most people don t realize that risk in hedge funds and active manager is driven by the parameter of the corresponding manger s opportunity to seek potentially higher returns and not by the investor s risk tolerance. The risk-targeting concept can also be thought of as risk rebalancing. Ultimately, an investor s risk tolerance is fixed over most time periods and likely decreases as he or she ages, holding other variables constant. This is not in conjunction with what most investors actually hold in their portfolios (an asset mix of 60/40, 40/60 etc.,), which varies widely over time. The conventional asset allocation portfolio s riskiness is independent of the investor s risk tolerance. Regardless of their risk tolerance, investors are taking more risk when the market is riskier and taking less risk when the market is less risky. With the targeted risk approach I propose, the investor is conceptually buying more of the relatively riskier assets during periods of low overall risk and buying more of the least relatively risky assets during periods of high overall risk. TWST: Though this fund might not be suitable for all investors, would you give us a description of your typical clients who are interested in alternative strategies? Mr. Flaig: A majority of our investors will be financial intermediaries. Most of these intermediaries are turning to tactical and alternative strategies to increase diversification, boost returns, and help manage risk. If the investor s goal is to secure

9 M O NMONEY E Y M MANAGER A N A G E R INTERVIEW I N T E R V I E W absolute i n vreturn e s t i n g strategies i n s t o c k s higher returns at a lower risk, then integrating the Arrow Alternative Solutions Fund into a traditional portfolio should help reduce portfolio volatility and improve the odds of preserving capital over the long term. Allocation to alternative assets is a strategy that many endowment managers (e.g. Harvard, Yale) are utilizing today. Prior to 1999, Harvard s investing was strictly limited to US stocks, bonds and cash. They recognized they were taking on too much risk and missed out on opportunities with alternative assets. Since 1999 they gradually started to shift away from traditional assets toward absolute return assets. Today, Harvard allocates 17% toward alternative assets and most endowments are allocating between 10% and 25%. These asset classes have the potential to deliver equity-like returns, but since they are not correlated with US equities, they cushion the portfolio against losses when the domestic stock market goes through its inevitable down cycles. One of our goals is to create value for our clients by offering investment strategies that seek to enhance returns and mitigate risk. Our first product, The Arrow DWA Balanced Fund, tactically provides exposure to four market segments (US equities, international equities, fixed income and alternative assets). Our tactical core is designed to be responsive to changing market conditions but it is missing exposure to absolute return strategies. The Arrow Alternative Solutions Fund enables clients to blend our tactical core Correlation of Alternative Asset product with a fund with absolute return strategies to create their own endowment solution for their clients. We have selling agreements with more than 200 of the top national, regional, independent broker/dealers and registered investment advisor-based platforms. Currently, more than 500 financial intermediaries are using the Arrow DWA Balanced Fund. We are focused on getting financial intermediaries to follow the endowment path of adding absolute return assets to their clients portfolios. We know that many of them are using hedge funds and managed futures strategies for their high net worth clients. The innovation of blending three alternative strategies within a low-cost mutual fund wrapper allows many of our clients to finally offer an absolute return strategy to investors who normally don t have access to this type of strategy. TWST: Is there anything that you would like to add? Mr. Flaig: Many of our clients ask us how much they should move toward alternative strategies. We typically tell our clients that the investor s risk profile should dictate that. However, the risk band of some alternative strategies makes it difficult to pin down a realistic allocation. Then we point the client toward the endowment path. Most endowments have already identified their allocations, which is critical for positioning their school assets and budgets. Their portfolios need to participate in strong upside markets while limiting their exposure to the downside. If they fail, the school assets drop and their operating budget is reduced, resulting either in a possible increase in tuition or the need

10 MONEY MANAGER INTERVIEW absolute return strategies to spend a portion of the endowment base during down markets. Many advisors need to look at their clients portfolios in the same light. There are 62 endowments funds that manage assets of more than $1 billion. Collectively, these endowments manage more than $229 billion and allocate 22.4% of their portfolios toward absolute strategies. Since 2002, that allocation has increased 26% during a very strong equity market. Many of our clients also ask us what component of the portfolio should be reduced. Most optimizers will reduce the riskier assets like equities. My advice would be to follow what the smart money is doing. The 62 endowments that we mentioned earlier have reduced their fixed income exposure by 39% since It makes sense. During the last three-year bear market (April 2000 to March 2003), the S&P 500 was down 16.1% a year while bonds were up 9.8%. Our alternative strategy, which we will use as a proxy for absolute returns, was up 12.9%. Since 1999, the strongest three-year period for the S&P 500 was from April 2003 to March During that period, the S&P 500 was up 17.2% a year but bonds were only up 2.9%. Absolute return strategies are designed to respond in all market conditions. While bonds provided the support during down markets, it typically does not participate equally when the markets are strong. Our alternative strategy over the same bull market period was up 12.7% a year. That is why endowments have reduced their fixed income exposure and maintained the same equity exposure since Absolute return strategies are typically not correlated to the movement of traditional assets. The beauty of the Arrow Alternative Solutions Fund is that it combines strategies that do not exhibit a high correlation to one another, potentially giving the investor an opportunity to reduce risk without sacrificing returns. We believe that in order to realize the benefit of diversification, a portfolio s underlying asset classes must behave differently in varying market conditions. If the investor s goal is to secure higher returns at a lower risk, integrating alternatives into a traditional portfolio should help reduce portfolio volatility and improve the odds of preserving capital over the long term. This is the value proposition of the Arrow Alternative Solutions Fund. TWST: Thank you. Note: Opinions and recommendations are as of November 1, An investor should consider the Fund's investment objective, risks, charges, and expenses carefully before investing or sending money. This and other information about Arrow Funds is contained in the fund's prospectus, which can be obtained by calling Please read the prospectus carefully before investing. Arrow Funds is distributed by Aquarius Fund Distributors AFD-11/20/2007 The Arrow Alternative Solutions Fund may not be suitable for all investors. The fund s use of derivatives such as futures, options and swap agreements may expose the fund to additional risks that it would not be subject to if it invested directly in the securities underlying those derivatives. Investing in leveraged instruments will magnify any gains or losses on those instruments. Investing in commodity and currency related securities may be subject to greater volatility than investments in traditional securities. The fund's use of short selling involves increased risks and additional costs. Investing in small-cap securities, may have special risks associated including wider variations in earnings and business prospects than larger, more established companies. The Fund may invest in fixed income securities, which are subject to risks including interest rate, credit and inflation. The maximum sales charge for Arrow s A-shares is 5.75%. A-share investors may be eligible for a reduction in sales charges. The Fund charges a fee of 1.00% on redemptions of shares held less than 30 days. The Arrow DWA Balanced Fund s annual operating expense is 2.01%. The Arrow Alternative Solutions Fund s annual operating expense is 1.52%.

11 MONEY MANAGER INTERVIEW absolute return strategies Definitions Volatility is a measure of fluctuations in value based on annualized standard deviation of monthly returns. Beta is a measure of relative risk. Correlation is similarity in performance to the equity markets. Sharpe Ratio measures risk-adjusted returns by taking the return less the risk-free rate, and dividing the result by the standard deviation. Absolute returns are generally positive rerturns in any market environment. Footnotes The Arrow Alternative Strategy reflects hypothetical or simulated performance figures and is not meant to represent actual performance results for the Arrow Alternative Solutions Fund. Past performance is not indicative of future results. Potential for profit is accompanied by possibility of loss. These figures reflect a simulated portfolio managed with the Arrow Alternative Strategy using actual & hypothetical performance data for various financial instruments based on Arrow Investment Advisors analysis. The simulated model was constructed using their proprietary set of rules for the purchase and sale of securities for each underling strategy as outlined in the Arrow Alternative Solutions Fund prospectus. There can be no assurance that actual transactions would have given the same results, although the manager believes results of actual trades would have been very similar. Performance results reflect the re-investment of dividends and other earnings. The performance results are net transaction costs and operating expenses associated with the management of the Arrow Alternative Strategy. The performance of the Hypothetical Arrow Alternative Strategy was reduced by 252 bps annually. Performance displayed represents past performance, which is no guarantee of future results. The information provided here is for informational purposes only, is not intended as investment advice and should not be construed as a recommendation with regard to investment decisions. Source for charts and graphs: Morningstar, Bloomberg, Deutsche Bank calculated by Arrow Investment Advisor, LLC. The index returns assumes re-investment of all dividends but do not reflect any management fees, transaction costs or expenses. The indices are unmanaged and are not available for direct investment. The Strategy benchmark comparison returns are comprised of three Credit Suisse / Tremont hedge Fund Indices: 33.3% Long Short equity, 33.3% Fixed Income Arbitrage and 33.3% Managed Futures indices. The Credit Suisse/ Tremont hedge Fund Indices are the asset-weighted benchmarks of hedge fund performance. It is not possible to invest in indexes which are unmanaged and do not incur fees and charges. The 60% equities and 40% bonds is comprised of S&P 500 and Lehman Aggregate Bond Index. The S&P Index is the Standard & Poor s Composite Index of 500 stocks and is a widely recognized, unmanaged index of common stock prices. The Lehman Brothers U.S. Aggregate Bond Index is an unmanaged index composed of investment-grade securities from the Lehman Brothers Government/Credit Bond Index, Mortgage- Backed Securities Index, and Asset-Backed Securities Index The Wall Street Transcript, 48 West 37th Street, NYC Tel: (212) Fax: (212) Website: