Alternative Investments Education Series

Transcription

1 UBS Alternative Investments June 2012 Alternative Investments Education Series This publication is a compendium of Alternative Investment reports, with a focus on hedge funds and private equity Sameer Jain, Head of Investment Content & Strategy (AI) sameer.jain@ubs.com, Alternative Investments: A Primer Hedge Funds Part 1 What are Hedge Funds? Part 2 Inside the Black Box Part 3 Asset Characteristics of Hedge Funds Part 4 Important Hedge Fund Strategies Part 5 Implementing a Hedge Fund Portfolio Part 6 Alpha Characteristics of Hedge Funds Private Equity Part 1 What is Private Equity? Part 2 Investing in Private Equity Part 3 Private Equity Strategies Part 4 Private Equity Portfolio Construction and Performance Measurement Part 5 Capital Commitment Considerations Part 6 Portfolio Diversification Part 7 Mezzanine Debt Part 8 Distressed Debt Please click the links above to jump directly to a section. UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

2 Editorial Dear Reader, The mission of UBS Alternative Investments is to leverage our relationships and networks in order to originate high quality investment opportunities for our clients. In doing so, we build on our reputation as a reliable, value-added and long-term partner. An important part of what we also do is to create thought leadership, co-author intellectual capital, as well as offer education. Alternative investments, when combined with a traditional stock and bond portfolio, offer potential benefits of diversification, low correlation, absolute return primarily resulting from manager's performance ability, and reduced volatility. The compendium, based on articles previously published in the UBS Alternative Investments Series, explores hedge fund and private equity investing issues. It is intended to serve as an alternative asset management primer for both new entrants, as well as experienced practitioners. The compilation highlights popular active management investment strategies, sub asset classes and expatiates on portfolio construction issues. The hedge fund collection within the compendium explains basic investing concepts, introduces ideas of credit and market risk arbitrage, explains popular trading strategies and provides examples of arbitrage trades in an easy to understand format. The series also explains hedge funds' asset characteristics, deciphers skill based components of returns and provides insights into the manner in which they may be included in investor portfolios. The private equity collection of reports included here explains the basics of private equity as an asset class, as well as the pros and cons of making illiquid investments. It highlights popular sub-sectors within private equity and points out salient considerations in capital commitments, performance measurement and portfolio construction. A couple of articles in the credit investing series elucidate on other topical themes such as mezzanine and distressed investing. We hope that this compendium will help further your understanding of this evolving space. Sameer Jain Head of Investment Content & Strategy UBS Alternative Investments - Americas

3 UBS Alternative Investments 25 April 2011 Alternative Investment Education Series Alternative Investments: A Primer The Alternative Investment (AI) universe consists of investments outside of publicly traded debt, equity, and real estate. It includes investments ranging from hedge funds (HF) and managed futures (MF) to venture capital and private equity (PE) funds, natural resource partnerships and private commercial real estate (CRE). Alternative investments are not new; HF have been around since 1949, the venture capital model had its roots in the 1940s, while investing in commercial real estate (CRE) has been around for hundreds of years. Characteristics Alternative Investment funds are generally not required to register under the Investment Company Act of 1940 and restrictions are placed on investors eligible to access them. They are not listed on an exchange and are offered as private investment funds available only to high net worth and institutional investors. UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. Alternative Investments have an absolute performance objective. As such, they do not merely seek to outperform a benchmark but rather aspire to produce positive returns under varying market conditions. They tend to use leverage to increase returns and their performance is largely dependent on investing skill rather than just market exposure. They have historically exhibited moderate correlation with traditional financial market indices over long periods of time. They typically also exhibit reduced liquidity relative to traditional investments, with monthly to multi-year lock-ups. Their managers typically charge higher fees, which may include performance fees. Historically, adding AI to traditional portfolios has often resulted in enhanced risk-adjusted returns. A feature that is common across most AI categories is the large dispersion of performance across managers and a degree of performance persistence. Therefore, even more so than for traditional investments, manager selection is of critical importance. 1

4 UBS Alternative Investments 25 April 2011 Four Broad Categories Alternative Investments tend to fall into four broad subtypes which differ from traditional assets in a variety of ways. Private Equity Funds: These are negotiated investments in privately held companies at different stages of maturity undertaken with the objective of improving their profitability and growth prospects and reselling them at a higher price in the future. PE fund managers often have increased access to information regarding private investments, while traditional money managers must rely on publicly-available information, because they only invest in the public markets. Also, they often invest based on a negotiated lower price, while traditional money managers typically pay market prices. They often create value and are able to exit acquisitions at higher multiples thus creating a profit for their investors. Hedge Funds: These funds invest in the global equity and fixed income markets and typically employ sophisticated trading strategies, use leverage and derivative instruments and go both long and short the markets. HF managers have the flexibility to invest opportunistically in strategies where they see value, unlike traditional money managers and mutual funds that are often constrained to invest in pre-defined markets. HF managers can short-sell the securities they believe will fall in value and thereby may profit from declining markets if they are correct in their judgment. In contrast, traditional money managers face limits on short-selling and may be required to be invested even if they believe markets are in a declining trend. HF managers can also use derivatives and leverage to hedge or magnify returns and risks, while traditional money managers are limited in their use of derivatives and leverage. Commercial Real Estate Funds: These are negotiated private debt and equity investments in real estate assets with the objective of generating current income and/or reselling at a higher value in the future. RE historically has experienced significant fluctuations. Cycles in value and local market conditions often influence investing outcomes. Most CRE investments employ leverage which has the effect of magnifying both gains and losses. It is important to remember that these investments are illiquid, are not listed on any exchange and are generally regarded as fixed and longterm. Generally, there are no liquidity provisions, no mechanisms in place to sell partial interests in nonrealized funds, along with significant restrictions on transfer. Managed Futures Funds: These funds are similar to HFs in some ways. They take exposure by using futures, options and forwards on traditional commodities, financial instruments and currencies. MF managers offer access to global futures markets through the use of professional money managers called Commodity Trading Advisors (CTAs). They use trading strategies and money management techniques to attempt to achieve profits and control risk. CTAs generally fall into one of two categories: Systematic or Discretionary. Systematic traders perform quantitative analysis on historical prices and follow either systematic or discretionary approaches to trading. Discretionary managers base investment decisions on the analysis of supply and demand, valuations and cyclical conditions. Risks in Alternative Investing Alternative Investments can pose risks beyond those that exist in traditional investments. For instance, the use of leverage can result in substantial losses if an investment does not behave the way the investment manager predicted, as leverage magnifies potential for both positive and negative returns. Alternative Investment managers are often compensated in part through incentive fees which may create the incentive to increase risk. Another source of risk is that reduced liquidity in certain markets may make it difficult to exit an investment during times of stress. Also, most private investment funds are subject to less regulation than their public counterparts, thereby reducing the level of supervision over an investment manager's activities. It is therefore important to measure these risks correctly so that they can be managed appropriately. The key is to recognize that the nature of risk in AI differs from traditional asset risk. Over time, returns in AI tend to be distributed in non-normal ways. Within traditional asset classes, it is often enough to understand expected mean (or average) returns and the volatility around the mean. In contrast, with AI it is important to acknowledge that there exists a higher probability of extreme events. In statistical terms, this is equivalent to saying that return distributions within AI are skewed and have fat tails. When return distributions are negatively skewed, this suggests a greater possibility of infrequent but substantial losses. Similarly, fat-tailed distributions (i.e. distributions with excess kurtosis in statistical jargon) imply a greater 2

5 UBS Alternative Investments 25 April 2011 frequency of large deviations from the mean, either positive or negative. When constructing portfolios that include AI, it is important, therefore, to understand how the characteristics of the portfolio will be affected beyond expected returns and volatility, and to include skewness and excess kurtosis considerations. Benefits & Considerations in Alternative Investing The addition of alternatives to a portfolio can potentially reduce volatility for a given level of expected return. In addition, investors for whom portfolio liquidity is not a concern may also be able to realize above-average returns arising from the illiquidity of the underlying assets. AI, in effect, allow investors to unlock what is known as illiquidity premiums. These are not available to the same extent within traditional assets. As market events are reflected differently in each strategy and in each broad AI category, combining a portfolio of such investments with different but complementary investment styles and risk/return attributes is desirable. However, a naive diversification across a large number of strategies may be suboptimal too. In AI, the process of due diligence is typically more time-consuming and more costly than in traditional investments. The reasons include the complexity of holdings and exposures, their diversity, and their lack of transparency. It is therefore important to choose carefully among selected strategies and amongst the managers that practice those strategies. One must also take care to skillfully combining them into robust portfolios. The construction of a portfolio of different AI strategies is a complex task requiring a deep understanding of the statistics commonly used in the financial industry as well as sound investing judgment. Private Equity PE funds pursue an investment approach based on acquiring control of companies to increase the market value of their pooled capital through active engagement and then exiting at a later stage at a profit. This engagement may include demands for changes in management, the composition of the board, dividend policies, company strategy, company capital structure and acquisition/disposal plans. PE funds sometimes also take a public company private for a period of restructuring before either returning it to public ownership or by selling it to another company or fund. Globally around $2,500 billion of capital has been raised and cumulatively deployed through fund investments. In addition, around $400 billion of committed, but uncalled, capital remains to be invested. Private Equity Strategies PE is an extremely heterogeneous asset class with many sub-sectors. These sub-sectors, which we discuss below, have very different asset characteristics. This means that each subsector has different performance drivers, which investors need to understand to make informed decisions. Leveraged buyouts: Leveraged buyout firms specialize in helping entrepreneurs to finance the purchase of established companies. Venture capital: These firms provide risk capital for starting, expanding and acquiring companies. Most are quite specialized, often investing in a single field, such as telecommunications or health care. Venture capital firms also tend to specialize by investment stage. Mezzanine capital: These funds provide an intermediate level of financing in leveraged buyouts below the senior debt layer and above the equity layer. A typical mezzanine investment includes a loan to the borrower, in addition to the borrower's issuance of equity in the form of warrants, common stock, preferred stock, or some other equity investment. Distressed Investing: This includes i) the purchase of companies that are distressed or outof-favor, for low multiples of cash flow and/or low percentages of asset value; or, ii) the acquisition of quality companies with excessive leverage or those that are going through bankruptcy that require restructuring. Special situations investing: Special situations investing is a broad category which encompasses variations of opportunistic distressed investing, equity-linked debt conversion plays, project finance, as well as one-time opportunities resulting from changing industry trends or government regulations. 3

6 UBS Alternative Investments 25 April 2011 Benefits & Considerations for Investing PE can be a source of attractive returns over the long term. Moreover, PE returns do not correlate closely with returns from traditional asset classes. They also provide access to selected growth opportunities even in low macroeconomic growth environments. This is because successful private equity managers are focused on picking companies with growth potential and actively creating conditions for growth, which investors can monetize. Properly implemented, the introduction of PE can improve portfolio diversification. They are however long-term oriented illiquid investments. Interests in PE funds are generally not readily marketable, transferable or redeemable. They have uncertain cash flows with respect to both capital calls and distributions. Also, they are a form of blind pool investing, since investors do not know beforehand what their funds will be invested in and must rely on the skills and judgment of the PE manager. Conclusion PE is an illiquid long-term oriented asset class, which, when approached with the necessary expertise, has the potential to improve the risk / return properties of an investment portfolio. PE is heterogeneous and includes several sub-sectors, all of which have their own unique characteristics. Given large dispersion of returns across managers and a degree of performance persistence, manager selection is of critical importance. Hedge Funds A HF, in essence, is an investment structure for managing a private, loosely regulated, investment pool that can invest in both physical securities and derivative markets on a leveraged basis. It may take the form of a limited partnership, corporation or trust. Hedge Fund Research Inc. estimates that, as of Q1 2011, there are around 9,418 HFs managing $2 trillion in capital. Despite the proliferation of funds over the years, assets in the industry remain very concentrated. HFs can be distinguished by their investment techniques i.e., short selling, use of leverage, dynamic trading strategies and derivatives. In general, HFs allow the fund manager to be active on both the long and short sides of the markets, compensate the fund manager with performance related-fees in addition to asset-based fees and allow the fund manager flexibility in investment style and approach. Hedge Fund Strategies HF strategies arise from taking speculative positions in a combination of market and credit risk instruments for which the manager believes that the risk-reward relationship is attractive. Such positions are often referred to as arbitrage, or risk arbitrage. Through such positions, hedge funds are able to implement a variety of non directional, semi-directional and directional strategies, whereby direction here refers to exposure to market direction. HFs are a heterogeneous group with over twenty distinct strategies within four broad strategy groups: Equity Hedge Strategies: Their main objective is to seek long-term capital appreciation while maintaining very low net exposure to the overall stock market, individual industry groups, and other proxies of systematic risk, such as measures of value, growth, book leverage, or size. Event Driven Strategies: Event Driven strategies concentrate on the profit potential created by major corporate events, such as mergers, acquisitions, restructurings, bankruptcies or liquidations. Macro Strategies: Macro Strategies primarily trade in the most liquid markets in the world, such as currencies and government bonds, typically betting on macroeconomic events such as changes in interest rate policies or currency devaluations. They rely mostly on an assessment of economic fundamentals. Relative Value Strategies: Relative value strategies seek to profit from the relative mispricing of related assets, e.g. convertible bonds and the common stock underlying the conversion option; options and futures and their underlying reference assets; debt instruments of the same issuer or of different issuers with different maturities or yields. 4

7 UBS Alternative Investments 25 April 2011 Benefits & Considerations for Investing One can think of HF returns as a combination of exposure to macro factors (economic exposure or beta ), fund-level elements (fees structure, trade implementation capabilities) as well as manager skill (or alpha ) in processing security or market specific information. The excess returns that some HF managers exhibit is a result of cheaper trading costs (due to large volumes and turnover), better market access and superior information processing abilities. HFs do, however, as alluded to earlier, pose unique risks that must be understood and managed. Conclusion Well-managed HFs have the potential to offer riskadjusted returns that are superior to those of traditional investments by taking advantage of market inefficiencies. Given the historically low correlation of certain strategies with traditional asset classes, HFs have often enhanced returns in economic environments in which traditional stock and bond investments have offered limited opportunities. HFs, given their flexible mandates, also allow investors to participate in a wide variety of new financial products and markets not available within traditional asset classes. Commercial Real Estate CRE investing includes making equity or debt investments in multi-family residential, land, office, industrial, retail, hotel properties and other more specialized assets. A significant advantage of CRE is that investors can gain access to this segment through a number of different vehicles and structures that provide different types of opportunity at different points in the business cycle. It is important to remember that the CRE market does not necessarily move in tandem with the residential housing market. It is driven more by economic factors such as economic growth, job creation, consumption and inflation. An Alternative Asset Investing in CRE is regarded as an Alternative Investment as it uses absolute return as its performance yardstick, while traditional investments use relative return. These investments utilize anywhere from 30 to 75% leverage, while traditional investments typically do not rely on leverage. Historically, CRE has had a relatively low correlation with financial market indices. Over the long term CRE has also been less volatile when compared to traditional investments such as equities and fixed income. Also, CRE is a physical asset and is relatively illiquid, as opposed to traditional investments which are financial assets and are highly liquid. Lastly, real estate is typically considered a better inflation hedge than traditional investments. This is because as inflation rises, the value of real estate usually increases, whereas traditional investments such as stocks are usually hurt by adverse inflation surprises. CRE Strategies Private Debt: This includes whole loans, mezzanine loans and B notes. A whole loan is a term used to distinguish between an original mortgage loan and a pass through security. A mezzanine loan is a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. A B-Note refers to the tranche that is subordinate to the investment grade portion of mortgage debt. In addition, investing in CRE through private debt typically produces steadier returns than CRE equity investments as they are less sensitive to economic conditions. The disadvantages involved in private debt include limited upside potential and lower liquidity due to the mid-level structure, as well as difficulty in creating diversified portfolios due to the concentrated nature of debt positions. Public Equity: Investors can gain exposure to CRE through public equity markets in two ways: Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). Both are types of companies that invest in real estate and whose shares are traded on exchanges. REITs invest in real estate directly, either through equity stakes in properties or through mortgages. They must distribute 90% of their earnings to shareholders and thereby qualify for lower corporate tax treatment. REOCs are similar, except that they reinvest earnings into the business and do not enjoy preferential tax treatment. They engage in the development, management or financing of real estate. Both REITs and REOCs are often traded on a long-short basis by HFs. Private Equity: This includes: core, core plus, value-added and opportunistic strategies. Core 5

8 UBS Alternative Investments 25 April 2011 refers to a low risk/low potential return and unleveraged strategy. Core plus refers to a low risk/low potential return and leveraged strategy. Value-added refers to moderate risk/moderate return and higher leverage strategy, while opportunistic refers to the highest risk/highest potential return and highest leverage strategy. Core has been the bulk of most investments, and usually involves investments in stable, fully-leased, multi-tenant properties within strong, diversified metropolitan areas, owned with little or no mortgage debt. Core funds also have highly predictable cash flows. Value-Added funds usually involve substantial redevelopment or re-leasing of a property to increase its potential value at a rate in excess of general market trends. Opportunistic funds include new property development and heavily leveraged property ownership. They are usually focused on off-market deals that have significantly higher risk profiles. Conclusion Properly selected CRE strategies have the potential to create current income along with capital appreciation. Moreover, CRE is usually also considered a hedge against inflation. It offers direct ownership and can expand the efficient frontier in a portfolio. The flip side to this is that investors may have to accept illiquidity and be ready to invest for the long term. Managed Futures MF offer access to global futures markets through the use of professional money managers called Commodity Trading Advisors (CTAs) who implement strategies using futures contracts. A futures contract is an exchange traded, liquid, standardized contract which specifies that the parties involved agree to buy or sell a certain underlying instrument at a specified price at a certain date in the future. Futures markets provide exposure across all major asset classes, including those based on interest rates, equity indexes, foreign exchange, energy, agricultural commodities and metals. These markets tend to be very active, liquid and deep. CTAs attempt to achieve capital appreciation primarily through trading of commodity, exchange traded futures and options, exchange cleared over-thecounter instruments, and swaps. They typically follow either Systematic or Discretionary approaches to trading. MF Strategies Systematic CTAs utilize quantitative research techniques to arrive at trading algorithms and proprietary trading models to exploit inefficiencies or capture trends in markets. Often, decisions are made based on computing rules arrived through statistical data analysis. For instance, they may evaluate momentum in prices by assessing for serial correlation to arrive at views on future prices. They may study volatility to determine if sudden price movements exceed caps or thresholds and accordingly scale their trading positions. Their trading models tend to fall into two broad camps. (i) Trend Following; and (ii) Relative Value. o Trend Following: These strategies are profitable if they are able to identify a trend that subsequently emerges during a period of increased volatility. However, they can experience losses when trends reverse. o Relative value: These, as the term suggests, are focused on identifying temporary mispricing between related financial instruments. Some examples of these mispricings may be in foreign exchange carry strategies, where one may borrow at cheaper rates in one currency and lend at a higher rate in another, yield-curve rich/cheap strategies, and spread trading. If prices do not move in the anticipated direction, or take a very long time to do so, these strategies result in losses. Discretionary CTAs make trading decisions on the basis of their own expert judgment and trading instinct, not necessarily on the basis of trading signals generated by any program, model or algorithm. Many Discretionary CTAs are also called Fundamental. CTAs using this Fundamental approach attempt to predict future price levels by studying external fundamental factors, namely supply and demand for a particular group or type of underlying. They may, based on their qualitative judgments, buy undervalued commodities and sell overvalued commodities simultaneously. 6

9 UBS Alternative Investments 25 April 2011 Gaining exposure Investors may gain exposure to MF in a variety of ways. For example, they may invest through pooled investment vehicles. These pooled investment vehicles or funds are typically structured as a limited partnership, L.P. or a limited liability corporation, L.L.C. Investors may also gain exposure to MF through managed accounts directed by CTAs, which have discretion to trade on the investors behalf for a fee. Another way is through a mutual fund type structure. In addition to this there are a variety of actively and passively managed MF indices. other alternative investments, a fair degree of transparency as well as the potential for long term capital appreciation. More importantly they have low correlation with other AI and traditional assets. Conclusion MF allow investors to participate in the global futures and forwards markets of commodities, foreign exchange, equity indices, and interest rates sectors. They offer access to global markets, bring professional management, provide relatively better liquidity than 7

10 UBS Alternative Investments 25 April 2011 Alternative Investment Funds Risk Disclosure Interests of Alternative Investment Funds (the Funds ) are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of the Funds, and which Clients are urged to read carefully before subscribing and retain. This communication is confidential, is intended solely for the information of the person to whom it has been delivered, and should not be reproduced or otherwise distributed, in whole or in part, to third parties. This is not an offer to sell any interests of any Fund, and is not a solicitation of an offer to purchase them. An investment in a Fund is speculative and involves significant risks. The Funds are not mutual funds and are not subject to the same regulatory requirements as mutual funds. The Funds' performance may be volatile, and investors may lose all or a substantial amount of their investment in a Fund. The Funds may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Interests of the Funds typically will be illiquid and subject to restrictions on transfer. The Funds may not be required to provide periodic pricing or valuation information to investors. Fund investment programs generally involve complex tax strategies and there may be delays in distributing tax information to investors. The Funds are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits. The Funds may fluctuate in value. An investment in the Funds is long-term, there is generally no secondary market for the interests of the Fund, and none is expected to develop. Interests in the Funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period of time before making an investment in a Fund. Investors should consider a Fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, there are risks specifically associated with investing in hedge funds, which may include those associated with investing in short sales, options, small-cap stocks, junk bonds, derivatives, distressed securities, non-u.s. securities and illiquid investments. This document is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS Financial Services Inc. has no obligation to update such opinion or information. Options are risky and are not suitable for everyone. Please read the Options Clearing Corporation Publication titled "Characteristics and Risks of Standardized Options Trading". This Publication can be obtained from a Financial Advisor, or can be accessed under the Publications Section of the Option Clearing Corporation's website at optionsclearing.com. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 8

11 UBS Alternative Investments 7 January 2011 Hedge Fund Education Series Part 1: What are Hedge Funds? Reports in this series Report Highlights Page Part 1: What are hedge funds? Industry size 3 Industry consolidation 4 Heterogeneity in trading strategies 5 Hedge funds compared to mutual funds 6 Alternative mutual funds 7 Industry regulation 8 Investor suitability 8 Fee structure 9 Hedge fund flexibility comes at a cost 10 Liquidity constraints and costs 10 Investor reporting 11 Conclusion 11 UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. This primer is designed to assist investors in furthering their understanding of the hedge fund space. It explains the basics of hedge funds, introduces concepts of credit and market risk arbitrage, explains popular trading strategies and provides examples of arbitrage trades in an easy to understand form. The primer series also explains hedge funds' asset characteristics and provides insights into the manner in which they may be included in investor portfolios. It is intended to serve as an investor's quick guide to hedge fund investing. The alternative investment universe consists of investments outside of publicly traded debt, equity, and real estate. It includes investments ranging from hedge funds and managed futures to venture capital, private placements, private equity LBO funds, natural resource partnerships, private real estate and commodity investments. The alternative investment industry is changing - maturing, expanding and increasing in complexity. At the same time, it has attracted interest from a growing number of institutional and individual investors. Individual investors have begun to increasingly embrace alternative investments, which, when added to a traditional investments, have the potential to diversify an investor's portfolio, and have historically had a lower correlation to traditional equity and fixed income investments. But even market-seasoned investors may find certain types of alternative investments, in particular hedge funds, all but impenetrable. Hedge funds present unique risks that differ from traditional investments. Also, in most cases, the primary source of hedge fund returns is from manager skill and security selection, rather than from directional asset class exposure. The superior return characteristics of hedge funds are also, at least in part, driven by risk control processes that are central to the 1

12 UBS Alternative Investments 7 January 2011 goal of producing positive returns in most, if not all, market environments. Even though modeling and measuring these risks presents challenges, from an optimal portfolio construction perspective, it may often be beneficial to include hedge funds. Hedge funds have the potential to provide access to additional sources of return by allowing investors to participate in a wide variety of new financial strategies and markets that are not available to traditional stock and bond investors, and may also diversify a traditional portfolio. Hedge funds have become increasingly popular over the last ten years. Hedge Fund Research, Inc. (HFR) estimates that that there are close to 9000 funds in existence with approximately $1.76 trillion assets under management (AUM). In 2000, this number was less than $500 billion. As hedge funds have gained stature and prominence, the term "hedge fund" has developed into a catch-all classification for unregistered privately managed pools of capital. A hedge fund, in essence, is an investment structure for managing a private, loosely regulated, investment pool that can invest in both physical securities and derivative markets on a leveraged basis. It may take the form of a limited partnership, corporation or trust depending on where the fund is domiciled and the type of investors it seeks to attract. 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. They can be distinguished by their investment technique (i.e., ability to short 1 sell, employ leverage, utilize dynamic trading strategies and derivatives) as well as their unique structure (i.e., largely unregulated limited partnerships). In general, hedge funds: Allow the fund manager to be active on both the long and short sides of the markets. Compensate the fund manager with performance related fees in addition to asset-based fees. Allow the fund manager flexibility in investment style and approach. Where hedge funds fall within the universe of investment opportunities versus more traditional investments is illustrated in Figure 1. Figure 1: Alternative investments complement stock and bond investing Investment Universe Alternative Investment/Non-traditional Assets Traditional Investments Private Equity/ Debt Venture Capital, RE Commodities Hedge Funds Stocks Bonds Private stakes in companies or real assets Ownership of commodities or listed commodity derivatives Long and short positions in publicly listed securities and their derivatives Long positions in publicly listed stocks Long positions in publicly listed bonds Source: UBS. RE = real estate 2

13 UBS Alternative Investments 7 January 2011 Industry size Although high net worth individuals have historically been investors in hedge funds, in recent years, institutional investors, mostly pension funds and endowments, have been a growing presence. Around 2001, after the internet bubble burst, university endowments began increasing their allocation, responding in part to the lackluster performance of technology, media and telecom equity markets. Following the lead of university endowments, pension plans too have been increasing their allocations. The hedge fund industry has continued to grow in terms of both AUM and number of funds, as shown in Figure 2 and Figure 3. Figure 2: Growth in hedge fund assets resumes Estimated growth of assets and net asset flow in hedge fund industry Assets ($MM) $2,000 $1,500 1,868 1,769 1,600 1,668 1,648 1,465 1,407 $1, ,105 $500 $ (1) (154) (131) -$ Q Estimated Assets Net Asset Flow Q Source: HFR Industry Reports, HFR, Inc., 3

14 UBS Alternative Investments 7 January 2011 Figure 3: Number of hedge funds still off 2007 peak Estimated total number of hedge funds and fund of funds 10,000 10,096 9,462 9,284 9,045 9,059 9,083 9,175 8,661 8,000 7,436 Number of Funds 6,000 4,000 2, ,454 3,873 3,617 3,325 2,990 2,781 2,383 1,945 1, ,105 5,379 6, Q Q Source: HFR Industry Reports, HFR, Inc., Industry consolidation Because there are thousands of potential investors in hedge funds and, traditionally, entry barriers to setting up such funds had been low (this is changing with enhanced regulation), such funds have proliferated. However, at the same time, a part of the hedge fund industry is consolidating around a relatively small number of large players that are well defined by a group of identifiable trading styles and strategies. Funds of hedge funds and investment consultants have identified and steered investments into a select group of larger and more established managers. The top firms tend to be larger and better organized; have longer track records, have developed improved systems and risk management processes; and, be more transparent and better understood by their clients, partly due to their high visibility. These select groups of money managers have identifiable brand names, significant AUM and, more importantly, a verifiable track record of at least three or more years. Despite the proliferation of funds over the years, the industry, in terms of AUM, remains very concentrated. Around three fourths of AUM reside in very large firms i.e. less than 500 firms, with the top 100 managing most of the capital. The industry AUM distribution is depicted in Figure 4. house multiple managers and decision makers; offer diversified trading approaches, 4

15 UBS Alternative Investments 7 January 2011 Figure 4: Bulk of AUM is with large firms Distribution of industry assets by firm AUM tier, Q By firm size (AUM) making them quite undecipherable to all, but academics. This education series attempts to uncloak the mystique. Examples of strategies 61% 2%2% 3% 5% 26% Convertible Arbitrage funds typically attempt to extract value by purchasing convertible securities while hedging the equity, credit, and interest rate exposures with short positions of the equity of the issuing firm and other appropriate fixed-income related derivatives. Dedicated Shorts are funds that specialize in short selling securities that are perceived to be overpriced, typically equities. By number of firms 5% Long/short equity funds are typically exposed to a long-short portfolio of equities with a long bias. Emerging Market funds specialize in trading the securities of developing economies. 7% 11% Equity Market Neutral funds typically trade long-short portfolios of equities with little directional exposure to the stock market. 9% 52% Event Driven funds specialize in trading around corporate events, such as merger transactions or corporate restructuring. 14% < $100 Million $100 - $250 Million $250 - $500 Million $500M - $1 Billion $1 - $5 Billion > $5 Billion Source: HFR Industry Reports, HFR, Inc., Heterogeneity in trading strategies Hedge funds form a heterogeneous group that utilizes many different strategies in delivering returns. These returns can be quite different from each other. There are over 20 hedge fund strategies, the important ones being described in detail in Part 4 of this series. These strategies are simple to understand but have been cloaked in jargon Fixed-Income Arbitrage funds typically trade longshort portfolios of bonds. Macro funds bet on directional movements in stocks, bonds, foreign exchange rates, and commodity prices. The risk and return attributes of hedge funds are determined by their investment strategy. The common element amongst strategies is the use of investment and risk management skills to seek positive returns regardless of the direction of equity and bond markets. Most of the well performing hedge funds place particularly strong emphasis on the disciplined use of investment and risk control processes. This can potentially generate returns with both low volatility and a low correlation with traditional equity and fixed income benchmarks. Unlike most traditional stock and bond investments, hedge funds often use leverage (described in Part 2 of 5

16 UBS Alternative Investments 7 January 2011 this series) for both return and risk management purposes. Some hedge fund strategies also use leverage to increase either the size or the number of positions in the fund s portfolio. Some strategies involve the use of leverage to amplify the small residual returns generated by spread trades, the risk of which is lower than outright directional trades. Also, leverage in the form of short selling is often used to hedge, i.e. offset, the portfolio s directional market exposure, which is intended to reduce some market risk. Hedge funds compared to mutual funds For traditional investments, mutual funds have been popular investment vehicles. A mutual fund raises money from shareholders and invests it in a group of assets, in accordance with a stated set of objectives. As an alternative investment vehicle, a hedge fund is fundamentally different from a mutual fund -- relative to mutual funds, hedge funds attempt to attain a positive return with a low directional market exposure (referred in the financial jargon as beta). Figure 5: Differences between hedge funds and mutual funds Hedge funds Managed by a manager who receives a management fee and who also participates in investors' profits. Available to qualified investors, high-net worth individuals and institutions by a confidential offering memorandum and a partnership agreement. Privately offered and typically not allowed to advertise. Minimal limitations by the SEC in the securities or strategies they may use. Entry is significant - $250K to $1MM+. Illiquid. Investors may not be able to redeem shares at any time. Usually a lock-in period. Mutual funds Managed by a fund manager who typically does not profit in investor's profits, but who gets paid the same fee, the management fee, regardless of whether investors profit or lose. Available to the general public by prospectus. Can advertise. Subject to SEC regulations by way of strategies they can use and underlying instruments that they can invest in. Entry is usually from a few thousand dollars. Redeemed daily on the open markets. Sometimes a fee to redeem early; shares can be bought or sold daily when market is open. Source: UBS Besides the differences listed in the above table, hedge funds lack the transparency the mutual funds have; as inherently private investment vehicles this secrecy is partly on account of the fact that managers engage in trading tactics which run the risk of being jeopardized, were the specifics of their trading positions be exposed to clients, and by extension to other traders. Because most hedge fund charters allow their managers wide latitude in investment instruments and strategies, style drift, in which a hedge fund s investments falls outside their stated investment style, occurs more frequently than desired. These concerns are being dealt with at a number of levels - regulatory, legislative, industry and banking, resulting in improvements in the transparency and risk management practices of the leading hedge funds. 6

17 UBS Alternative Investments 7 January 2011 Alternative mutual funds Traditional investment companies and mutual funds, institutional asset managers and bank owned asset management firms have been developing alternative investment programs, attracted by their high fees, incentive compensation and ability to provide diversification from traditional investment vehicles. The ability of mutual funds to offer hedge fund programs was made possible by the SEC s removal of the shortshort rule, which dictated that mutual funds may not derive more than 30% of their profits from short-term trading and short selling. However, mutual funds are still required to have 300% coverage on debt - thus they can only leverage up to 1/3 of their equity. A number of mutual fund companies now offer hedge funds, especially sector and market-neutral funds, within their range of investments. Regulatory changes are blurring the boundaries of what were once classified as traditional investments from alternative investments. Many long-only large asset management firms, that in the past dealt with traditional only -type products have begun offering hedge fund strategies; they employ hedge fund techniques such as short-selling and leveraging trades. In the same vein, some traditional hedge funds have begun offering their strategies in a mutual fund format - ostensibly to attract retail investors that were precluded from investing in hedge funds. Both traditional managers and hedge fund managers stand to benefit from increased fund flows, the ability to offer higher margin products, and revenue diversification. A number of long-only traditional funds, when offered in a hedge fund format offer monthly liquidity, sometimes impose short lock-ups and ask for both management and performance fee. Certain strategies such as long-short, that exhibit greater correlation with equity markets and in general have a long only bias, are more suitable than others (such as those with illiquid underlying holdings) to be offered in mutual fund formats. Other hedge fund strategies that have gained traction include marketneutral, commodity investing and currency funds. This is because these strategies can be implemented using very liquid underlying instruments such as futures and options. Probably the greatest advantages to investors accrue from increased transparency, low minimums, and greater liquidity (daily), reduced fees and stronger regulatory oversight. Appealing as they are prima facie, hedge funds wrapped as mutual funds are intended to serve as diversification vehicles, rather than as skill based (or alpha ) vehicles. For some investors, the main reason to participate in hedge funds is to reap higher returns, rather than to achieve portfolio diversification, believing that diversification can be cheaply arrived by using other investment vehicles. In such cases, employing hedge funds in a mutual funds structure may be less than optimal. In certain cases, though not all, hedge funds wrapped as mutual funds may structurally inhibit the flexibility need for alpha generation for a number of reasons: Mutual funds have restrictions on leverage, as mentioned earlier, where only a third of the fund can be leveraged. The average leverage in the hedge fund industry depending on the strategy is 1.8 to 3 times, considerably higher than in mutual funds. The higher leverage in hedge funds may help increase returns, but it of course, also has the potential to magnify losses. Mutual funds are required by the Investment Company Act of 1940 to provide daily liquidity - less than 15% total fund AUM can be invested in relatively illiquid underlying instruments. This prohibits such vehicles from unlocking the illiquidity premium in underlying securities. Hedge fund investments are considerably less liquid than portfolios of traditional assets. They generally allow quarterly or less frequent withdrawals, generally after a one-year initial commitment. On the positive side, limited withdrawal frequency does let managers focus on longer-term performance without the distraction and demands of, in many cases, daily withdrawal rights provided by traditional managers. This can improve performance. The flip side to this is it creates a perverse incentive on the part of the hedge fund manager to hold on to underperforming securities in the hope that they may some day recover in price in the future. 7

18 UBS Alternative Investments 7 January 2011 Mutual funds have restrictions on the usage of derivatives. Such restrictions curtail efficient ways to both gain exposure and to hedge - which often reduces skill-based alpha -generation potential. However, derivatives when improperly employed can prove to be very risky. Mutual funds have restrictions on the incentive fees that they can charge. The best investment professionals may not be attracted to such fund complexes. However, there is evidence (albeit inconclusive) that higher management fees and incentive compensation can significantly limit afterfee returns available to investors. Many hedge fund strategies cannot be successfully implemented in the open-end format; such as global macro, fixed income arbitrage, or distressed investing, which may require the use of leverage, expression through derivatives, or holding of illiquid securities - all of which are restricted in the mutual fund world. It is for this reason that only certain hedge fund strategies, as highlighted earlier, have gained traction in mutual fund formats. Hedge fund strategies have flexible mandates which allows for manager strategy to evolve as market conditions change. Mutual fund structures are not allowed to have flexible investment mandates - most have narrowly defined charters, a practice driven by industry and regulatory convention. While the investment flexibility that hedge funds enjoy has numerous benefits it does entail the risk of style drift within any given fund. Industry regulation Historically, the offer and sale of securities within the United States has been subject to concurrent federal and state regulation under the Securities Act of 1933 (the Securities Act ) and state blue sky laws. In order to avoid the registration and prospectus delivery requirements of the Securities Act, securities of hedge funds and offshore funds are typically offered in private placement transactions which rely on the private placement safe harbor provisions of Regulation D, or the safe harbor for offerings outside the United States contained in Regulation S. The exclusions from registration under the federal securities laws that apply to hedge funds and their securities offerings are central to hedge funds ability to operate in their current form. The exclusions define the investment strategies that hedge funds may pursue, the types of investors who generally may invest in them, and how they may be sold. Hedge funds are able to avoid certain regulations by meeting criteria that is laid out in four general exclusions or exceptions: 1) the exclusion from registration of the fund under the Investment Company Act of ) the exemption from registration of the fund's securities under the Securities Act of ) the exception from registration of the hedge fund manager under the Investment Advisers Act of ) the exception from reporting requirements under the Securities Exchange Act of Investor suitability In the U.S., hedge fund investment is restricted to sophisticated, qualified high net worth individuals and institutions who are presumed to understand the risks that hedge fund investing entails, and who, theoretically can afford to lose their invested principal. Generally, hedge funds accept investments only from qualified purchasers and registered hedge funds accept investments only from qualified clients. Generally, a qualified eligible person is an accredited investor that owns securities of issuers not affiliated with such person with an aggregate market value of at least $2 million. In some other countries, hedge funds are more strictly regulated. Hedge funds are not for every financially qualified investor. Furthermore, not all hedge fund strategies may be appropriate even for the qualified, informed and sophisticated investor. Nevertheless, a judiciously chosen allocation to hedge funds may be beneficial for those qualified investors who have educated themselves about hedge funds and are willing and able 8

19 UBS Alternative Investments 7 January 2011 to accept those risks. As a general rule, the risks of investing in a particular hedge fund are described in the fund s confidential private offering. Many hedge fund offering documents state An investor should carefully review and consider such risks, and consult with financial and tax advisors, before making an investment in... Other risks associated with hedge funds investments include, but are not limited to: They can be highly illiquid. Hedge fund managers may limit the ability of investors to withdraw funds. This limitation may be done in different forms and will sometimes prevent investors from accessing their investments in periods that can exceed one year after the initial investment. These limitations are in themselves a potential source of risk because they constrain the ability to rebalance investor portfolios, meet liquidity events or react to manager underperformance. They are not required to provide periodic pricing or valuation information to investors although managers do provide investors with reports. They may involve complex tax structures and delays in distributing important tax information. They are, as mentioned earlier, not subject to the same regulatory requirements as mutual funds. Fee structure The fees in the hedge fund industry are higher, than those charged in the traditional fund management industry. While a typical long-only manager may charge bps of AUM, hedge fund managers usually charge a management fee of 2% and 20% of the profits known as incentive fees. Some funds are able to command above average fees because they have historically provided superior risk-adjusted returns and often have very limited capacity to accept additional investors. This is simply a case of supply and demand; the relatively small number of superior hedge fund managers are in such demand that they are under no business-related pressure to acquiesce by dropping their fees. Performance-based compensation has the potential to create positive manager selection. The hedge fund structure is attractive to top tier talent as it affords greater financial rewards to managers who can deliver net performance on large pools of investor capital. The incentive fee is a percentage of profit above a base, typically, the asset value at the beginning of the year. It is generally subject to a high watermark provision. Being under the watermark means that, in the short run, the manager will not receive any incentive fees. This is sometimes cited as a cause for hedge funds going out of business after periods of sub-optimal performance. They often charge higher fees and the high fees may offset trading profits. They may have performance that is volatile. There is no secondary market for an investor s interest in the fund. They may have restrictions on transferring interests in the fund. Strong rewards can thus be linked to fund performance. Hedge fund managers are usually invested in their funds and share the rewards as well as risks with their investors. The "incentive fee" remunerates hedge fund managers based on performance benchmark, whereas mutual funds pay their financial managers according to the volume of assets attracted, regardless of performance. 9

20 UBS Alternative Investments 7 January 2011 Figure 6: Many funds are below their high watermark (HWM) suggests higher closure risks HFRI Fund Weighted Composite Index, % of constituent funds at high watermark % of Funds at HWM Q Source: HFR Industry Reports, HFR, Inc., Hedge fund flexibility comes at a cost While we have highlighted many benefits that investments in hedge funds can provide, it is important to understand that these advantages come at a cost: a) Fees. As described previously, this is the most visible cost in investing in hedge funds. They are split in two parts: management fees and performance fees. Management fees are a fixed cost and hence a direct drag on performance. b) Asymmetric downside risk. Having flexibility to invest in non-traditional securities and to use leverage, hedge funds are exposed to different sources and magnitudes of risk. If these risks are not properly managed, hedge funds risk losing a substantial part of their assets. The possibility of infrequent but substantial losses, which exceed in magnitude and probability those of normally distributed returns, is known as asymmetric downside risk. c) Liquidity constraints. On top of fees, hedge fund managers may limit the ability of investors to withdraw funds. This limitation may be done in different forms and will sometimes prevent investors from accessing their investments in periods than can exceed one year after the initial investment. These limitations are, themselves, a potential source of risk because it constrains the ability to rebalance the investor portfolios, meet liquidity events or react to manager underperformance. Liquidity constraints and cost A typical hedge fund agreement stipulates the redemption policy. This redemption policy has generally the following provisions that restrict investors from redeeming their shares: Lockup period: all initial monies allocated to their fund cannot be withdrawn for a certain period of time. After the initial lockup period, investors can redeem their shares only at certain periods. Lockup periods range from 3 months to 3 years although not all hedge funds impose lockups. For those funds that do impose lockups, the typical lockup period is one year. Redemption Frequency: after the lockup period, investors in hedge funds may redeem their shares. However, the redemption process is not continuous and investor can only redeem at certain points in time. The periods where investors are allowed to withdraw funds are controlled by the redemption frequency. For instance, if the redemption frequency is 3 months, an investor can only withdraw funds every 3 months after the lockup period has expired. This translates into a maximum of 4 withdrawing events each year. 10

21 UBS Alternative Investments 7 January 2011 Redemption frequencies can range from daily to annually. Not all hedge fund managers impose redemption frequency restrictions. Redemption notice: investors are generally required to give notice some time in advance before any redemption. This minimum notice period is known as a redemption notice period. Redemption notice periods range from 30 days to one year, although the most common periods notice periods are 30, 45 and 60 days. Some hedge funds do not impose a minimum redemption notice period. Hedge Fund liquidity constraints impose risks and costs to investors: 1) Investors are limited in their ability to make tactical decisions. Within the lockup period, investors are unable to reallocate their position in a hedge fund. After the lockup period, investors can only change their allocations infrequently. 2) The constraints that limit the potential for tactical hedge fund allocations also restrict investors from using hedge fund redemption to meet unforeseen liquidity events. 3) Certain restrictions introduce new forms of risk: particularly, the redemption notice introduces uncertainty with regards to how the investor s portfolio will look once the redemption is executed. This occurs because redemption notices need to be given long before they come due (if there is a redemption notice clause) and before the valuation period for the hedge fund shares. Hence, one cannot know with precision how much of the hedge fund allocation will be drawn when the redemption decision needs to be made. 4) Not all hedge fund strategies provide investors a premium for bearing liquidity restrictions. Strategies like Global Macro which are likely to invest in very liquid markets, do not provide additional returns to investors who face liquidity constraints. Investor reporting Generally, reporting is provided on month-to-date net performance estimate of NAV; the industry practice is for performance numbers to be reported net after all expenses, management fees and incentive allocations. For many funds, monthly reporting consists of a performance commentary, accompanied by portfolio analysis, including a breakdown of the portfolio (strategy, security type and geography), an analysis of exposure (gross long and short, net long or net short ), and their top positions by name. The investor s capital account statement is also sent monthly. At the end of each calendar quarter, an investor's capital account statement is accompanied by an investor letter, which often provides an in-depth narrative of the quarter in review as well as a look at current market conditions. Informally and intra-month, some hedge funds encourage their investors to call for updates on the portfolio and the markets. Hedge funds also send an audited financial statement to all shareholders following the end of each fund s fiscal year. Conclusion Well-managed hedge funds have the potential to offer returns that are superior to those of traditional investments by taking advantage of market inefficiencies. Given their historically low correlation to traditional asset classes, they have historically enhanced returns in economic environments in which traditional stock and bond investments have offered limited opportunities. Hedge funds, given their flexible mandates, also allow investors to participate in a wide variety of new financial products and markets not available in traditional investor products. 11

22 UBS Alternative Investments 7 January 2011 End Notes 1 During short selling the fund manager borrows securities that it does not own (and pays fees and interest rate charges for such borrowing). The manager then sells such securities with the goal of acquiring them later at a lower price. The manager then returns the borrowed securities and retains the gain (should security prices decline in value), if any, from selling the securities short. If the prices of the borrowed securities rise the manager looses money as those securities need to be bought back at a higher price (for they were borrowed in the first place). To buy and hold something is referred to as taking long exposure. Alternative Investment Funds Risk Disclosure Interests of Alternative Investment Funds (the Funds ) are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of the Funds, and which Clients are urged to read carefully before subscribing and retain. This communication is confidential, is intended solely for the information of the person to whom it has been delivered, and should not be reproduced or otherwise distributed, in whole or in part, to third parties. This is not an offer to sell any interests of any Fund, and is not a solicitation of an offer to purchase them. An investment in a Fund is speculative and involves significant risks. The Funds are not mutual funds and are not subject to the same regulatory requirements as mutual funds. The Funds' performance may be volatile, and investors may lose all or a substantial amount of their investment in a Fund. The Funds may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Interests of the Funds typically will be illiquid and subject to restrictions on transfer. The Funds may not be required to provide periodic pricing or valuation information to investors. Fund investment programs generally involve complex tax strategies and there may be delays in distributing tax information to investors. The Funds are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits. The Funds may fluctuate in value. An investment in the Funds is long-term, there is generally no secondary market for the interests of the Fund, and none is expected to develop. Interests in the Funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period of time before making an investment in a Fund. Investors should consider a Fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, there are risks specifically associated with investing in hedge funds, which may include those associated with investing in short sales, options, small-cap stocks, junk bonds, derivatives, distressed securities, non-u.s. securities and illiquid investments. This document is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS Financial Services Inc. has no obligation to update such opinion or information. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 12

23 UBS Alternative Investments 25 January 2011 Hedge Fund Education Series Part 2: Inside the Black Box Reports in this series Highlights Page Part 1: What are Hedge Funds? Part 2: Inside the Black Box Risks that Hedge Fund Managers Take 1 Market Risks 2 Interest Rate Risk 2 Prepayment and Extension Risk 3 Concentration and Liquidity Risk 3 Currency Risk 4 Derivatives Risk 4 Credit Risk 5 Credit Risk and Market Risk are Interconnected 7 General Trading Techniques 8 Leveraging 8 Short Selling 9 Hedging 9 Arbitrage 10 Conclusion 10 Part 3: Asset Characteristics of Hedge Funds Part 4: Important Hedge Fund Strategies Part 5: Implementing a Hedge Fund Portfolio UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. In order to confidently invest in hedge funds, it is useful to open the hedge fund black box and gain an understanding of investment and trading approaches employed by hedge funds managers. This issue lays out the building blocks of hedge fund performance generation. It examines the types of risk that hedge funds seek exposure in search for returns. It also highlights various hedge fund trading techniques. Risk and return are closely linked in financial markets. Not surprisingly, hedge funds ability to generate performance derives from their skills in taking calculated risks. The first part of this report covers in detail the broad array of risk sources that hedge funds typically seek exposure to. Risks that Hedge Fund Managers Take Hedge Fund investing and trading typically involves assuming a combination of market and credit risk. Market risk specifically addresses asset price risk. The market prices of financial instruments in which a hedge fund invests can be highly volatile. For instance, price movements of derivative contracts are influenced by, among other things, interest rates, market volatility, the price of the underlying asset or, changes in liquidity conditions. Changes in the financial market environment are often the fundamental cause for price moves, including changing supply and demand relationships, fiscal, monetary and exchange rate policy, or other national and international political and economic events. All these factors are ultimately uncertain and news about them can influence prices giving rise to market price risk. 1

24 UBS Alternative Investments 25 January 2011 Credit risks arise, simply put, when a debtor counterparty is unable or unwilling to service an obligation. Hedge fund strategies arise from taking speculative positions in a combination of market and credit risk instruments for which they believe that the risk-reward relationship is attractive. Such positions are often referred to as arbitrage, or risk arbitrage. They are at the heart of hedge fund activities. Through such positions, hedge funds are able to implement a variety of non-directional, semi-directional and directional strategies, whereby direction here refers to exposure to market direction, i.e. being long the market. Non-directional Non-directional strategies include a combination of convertible arbitrage, distressed securities, eventdriven, risk arbitrage, equity market-neutral, relative value arbitrage and statistical arbitrage. It is useful to remember that the correlation between absolute nondirectional return strategies and equity markets has been higher than the term non-directional might imply. This suggests that the case for non-directional return strategies should not be viewed as based on diversification grounds alone, although the correlations are still more attractive, in portfolio diversification terms, than most traditional assets or strategies. Semi-directional Semi-directional strategies include those with long and short positions, where the manager aims to maintain some limited, but varying ( long or short ) exposure to the underlying market direction. Directional Directional return strategies have historically produced lower returns when equity or fixed markets have fared poorly and higher returns when those markets have done well. Directional strategies explicitly retain exposure to some major market movement. They can involve concentrated portfolios (industry, or sector focused or global) together with strategies using macro bets (currency, theme, or market timing, for instance). They may be, for instance positions in emerging market fixed-income and equity markets, exposure to global macro themes or just to equity markets in general. Market Risks Interest Rate Risk Interest rates are the principal determinant of fixed income securities prices and they represent one of the most important factors contributing to a company s debt risk profile. Two commonly used measures of a security s sensitivity to interest rate changes are duration and convexity. These two measures provide an important framework for the evaluation of a security s sensitivity to interest rate movements. Duration measures the sensitivity of the market value of a fixed income security to changes in narrow bands of parallel interest rate movements. As interest rates deviate from a bond s initial yield, however, the accuracy of the duration measurement lessens. This is due to the convexity of the price/yield relationship for a fixed income security. Convexity, simply stated, is a measure of the rate and direction by which duration will change as interest rates change. For example, callable corporate bonds typically exhibit negative convexity; as interest rates fall, their values increase more slowly than non-callable corporate bonds of equivalent duration. Often adding a call provision, which is just a call option embedded in the bond, also reduces the duration of a fixed-coupon bond. Furthermore, as interest rates rise a situation that generally causes fixed income securities to lose value callable bonds may depreciate more quickly than other bonds of equivalent duration. Relevant Trade: Fixed income hedge fund managers discover and exploit inefficiencies in the pricing of bonds (by understanding duration and convexity characteristics) given changes or expected changes in interest rates. 2

25 UBS Alternative Investments 25 January 2011 Prepayment and Extension Risk Concentration and Liquidity Risk Mortgage Backed Securities (MBS) are created from mortgages which are pooled together, packaged, and sold through the issuance of pass-through certificates. Some MBS are also used to collateralize a specialpurpose entity that issues a series of debt-like instruments. The underlying mortgages are highly sensitive to interest rates because they may be prepaid earlier or later than expected by the borrower, depending on levels of interest rates. The repayment activity of the underlying mortgages, in turn, affects the repayment timing and duration of the MBS and therefore its market value. For example, as interest rates rise, home owners with fixed rate mortgages are less likely to prepay their mortgage obligations. This, in turn, potentially extends anticipated prepayments which increases the duration of these securities. This increase in duration may result in more price risk going forward. Additionally, delayed principal payments cause a greater decline in value for a typical MBS than for a traditional fixed-income security. Both mortgage pass-though securities and collateralized mortgage obligations (CMOs) generally exhibit negative convexity (i.e. the price impact of yield changes declines for lower mortgage rates). Mortgage prepayments are also influenced by a number of noninterest rate related factors, such as seasonality, the aging of the securities and certain macroeconomic factors including housing prices, bank financing charges, and expectations of economic prosperity. As a result, these types of securities cannot be analyzed in the same way as a treasury security or corporate debt. Relevant Trade: Mortgage Long/Short hedge fund managers model prepayment speeds and delinquency rates under a variety of scenarios to arrive at fundamental securities pricing and trade on the difference between their view on optimal value and market prices. Concentration Risk A portfolio of investments or activities is subject to additional risk when it exhibits a high concentration in a specific currency, industry, or security type. For example, concentrations in securities of a specific industry may expose a fund to undiluted industry risks that could lead performance to deviate significantly from general market trends. In similar manner, significant concentrations in specific security types may expose a fund to greater market price risk because of interest rate movements or other market conditions. For instance, security prices may drop as the demand for a specific security falls due to regulatory changes, the industry falling out of favor or because of a change in market risk perception. Relevant Trade: Hedge funds are often able to spot these opportunities and profit from premiums or discounts from concentration risk. Liquidity Risk Hedge funds sometimes invest in securities, bank debt and other claims which are subject to legal or other restrictions on transfer, or for which no liquid market exists. The market prices for such investments tend to be volatile and may not be readily ascertainable. Hedge fund managers run the risk that they may not be able to sell these securities when they desire to do so or to realize, what they perceive to be their fair value in the event of a sale. Also, the sale of restricted and illiquid securities often requires more time and results in higher brokerage charges or dealer discounts and other selling expenses than does the sale of securities eligible for trading on national securities exchanges or in the over-the-counter markets. If sophisticated investors, who do not require immediate liquidity for their investments, are able to hold on to these investments they often have the potential to receive handsome returns. In another case, highly complex securities that have very narrow markets may trade at lower prices which 3

26 UBS Alternative Investments 25 January 2011 reflect their lack of liquidity; a security s bid/ask spread may offer insight into its liquidity with larger spreads often indicating greater liquidity risk. Additionally, liquidity risk can be measured by the yield differential between a benchmark security at a specific maturity and a security with different attributes, but with a similar maturity. Relevant Trade: These risks result in temporary mispricing and which allows hedge fund managers to take long positions in securities that are expected to increase in value and short positions that are expected to decrease in value due to liquidity considerations. Currency Risk Foreign-exchange risk premiums represent the market s anticipated excess return to holding foreign currency relative to holding domestic currency. This risk premium can be time varying. Over the longer term it should be related to interest differentials and thereby to the economic environment in the respective countries. Relevant Trade: Currency hedge fund managers decipher and trade on exchange-rate risk premiums by considering relationships given interest differentials, the gap between current and long-run equilibrium exchange rates, and the expected change in long-run exchange rates, amongst other considerations. Also, global macro funds often express relative directional bets on countries using currencies rather than other vehicles due to the liquidity of these instruments. Derivatives Risk Derivatives risk is a very broad term that includes the use of derivative products such as futures, options, swaps, floating rate notes, structured notes amongst others. Utilization of derivative products for speculative purposes can increase risk. Conversely, the use of derivatives for hedging purposes can play a role in lowering risk. Relevant Trade: Hedge fund managers use listed and OTC options for hedging and speculative purposes. They also use credit default swaps to execute directional shorts and for hedging purposes. Market Risk Arbitrage Illustration Most hedge funds that trade on market risks aspire to pursue an active money management style designed to achieve consistent superior investment results irrespective of the returns generated by the overall markets. For instance, a market risk hedge fund manager may develop an investment philosophy that is value and event focused, specializing in the identification and analysis of securities that can benefit from extraordinary transactions. This manager may then choose to primarily invest in securities subject to restructurings, takeovers, exchange offers, spin-offs, financial reorganizations and other special situations. This approach has historically provided returns that are transaction specific and therefore largely uncorrelated with movements in other markets. The manager may frequently protect its positions directly or indirectly through opposing equity or derivative positions to promote principal safety and return stability. The manager may attempt to minimize its loss exposure in each specific situation by having position sizes determined by total potential loss as well as actively utilizing stop-loss trading techniques. The more sophisticated hedge funds determine the systemic risk in each position in addition to the event risk idiosyncratic to that position, factoring in the strategic, legal and interpersonal forces, completing an enterprise valuation, and modeling complex deal phenomena with various probability trees. Once risk is determined, it becomes a valuable input to determine position size. Further, risk assessment is a dynamic, not static. The good hedge funds employ a rigorous investment process to evaluate potential investment opportunities. Such a process often begins with the due diligence process, consisting of a thorough business review of the industry, competitive landscape, products, customers, return on capital and management of an issuer. This initial assessment is then followed by extensive asset valuation, financial analysis, cash flow analysis, legal and accounting review, and comparable credit and equity analyses. It often also includes a thorough assessment of how a particular investment fits into the overall investment strategy of the portfolio. This approach to market risk investing provides hedge funds with the potential to effectively arbitrage market risks. 4

27 UBS Alternative Investments 25 January 2011 Credit Risk Relevant Trades: Credit risk is very different from market risk. Credit risk is risk due to uncertainty about a counterparty s ability or willingness to meet its debt obligations. There are many types of counterparties from individuals to sovereign governments as well as many different types of obligations from auto loans, corporate loans, to derivatives transactions; therefore credit risk takes many forms. In assessing credit risk from a single counterparty, hedge funds almost always consider what they refer to as the default probability, their credit exposure and the amount they expect to recover in the event of bankruptcy or default. The default probability is an assessment of likelihood that counterparty will default on its obligation, either over the life of the debt, or over some other specified time period. Related concepts are credit exposure and recovery rates. Given that default has occurred, credit exposure is an assessment of how large the creditor s exposure is to the default. This is different from total loss, for the total loss depends in part on the amount that can be recovered. The recovery rate is an approximation of the exposure which may be recovered through bankruptcy proceedings or settlement. Credit hedge fund managers arrive at their own views of credit exposure and recoveries and take long or short positions in the underlying security. Many forms of credit risk - especially those associated with larger institutional counterparties - are complicated, unique, or are of such a nature that that it is worth assessing them in a less formulaic manner. The term credit analysis is used to describe any process for assessing the credit quality of a counterparty. While the term can encompass credit scoring, it is more commonly used to refer to processes that entail human judgment. In credit hedge funds, credit analysts examine balance sheets, income statements, industry trends and the economic environment to make informed speculative decisions. Mortgage Backed Securities (MBS) Arbitrage: These managers seek to identify and exploit long/short opportunities in U.S. Government Agency MBS, while seeking to neutralize the portfolio to interest rate sensitivity and varying prepayment rates. Opportunistic MBS: These managers attempt to identify and exploit opportunities in fundamentally undervalued complex MBS. Municipal Arbitrage: This takes advantage of the arbitrage opportunity between the tax-exempt and taxable markets by investing in long-term municipal bonds and hedging interest rate risk in the taxable markets. Relative Value Preferred: Managers trading in this space opportunistically invest in subordinated securities of high grade companies, while seeking to neutralize the portfolio to interest rate sensitivity and spread widening. Fixed Income Relative Value: These managers primarily focus on spread trading within high grade MBS. Asset Backed Securities (ABS): These managers deal in diversified ABSs and exploit inefficiencies in investment grade securities backed by hard assets (non-consumer based risk) and securitized corporate debt as well as various strategic short positions to extract value. Leveraged Loans: Hedge fund managers operating in this credit space seek to invest in a diversified portfolio of primarily senior, secured, and floating rate bank loans to non-investment grade companies. 5

28 UBS Alternative Investments 25 January 2011 Credit Risk Arbitrage Illustration Hedge Fund Trade Construction A corporation may have, for example: a) An over-leveraged balance sheet due to a failed acquisition or growth strategy. b) Deteriorating profitability due to a high cost structure, technological change, increasing competition, change in regulatory environment or litigation. c) An inability to refinance existing debt in the capital markets; or d) Poor management. Obligations of such a corporation may trade at a discount to their fundamental or recovery value for a variety of reasons, for example: a) Investor segmentation. Many institutional investors are either unable or unwilling to hold these obligations, and as a consequence may sell or refrain from buying without properly considering recovery prospects. b) Valuation difficulties. These obligations may be difficult to value for a variety of reasons such as a corporation s organizational complexity or legal circumstances, lack of transparency or rapidly changing financial situation; or c) Time delay. Investor interest may be reduced as a result of the length of time required to resolve corporate financial problems or the length and complexity of a workout or restructuring. Hedge funds may invest in the debt of such companies by taking long or short directional exposure in its debt/ high-yield securities. Such securities are generally not exchange-traded and, as a result, these instruments trade in the over-the-counter marketplace, which is less transparent than the exchange-traded marketplace. In addition, many hedge funds will invest in bonds of issuers that do not have publicly traded equity securities, making it more difficult to hedge the risks associated with such investments. These securities face ongoing uncertainties and exposure to adverse business, financial or economic conditions which could lead to the issuer's inability to meet timely interest and principal payments. The market values of certain of these lower-rated and unrated debt securities tend to reflect individual corporate developments to a greater extent than do higher-rated securities which react primarily to fluctuations in the general level of interest rates, and tend to be more sensitive to economic. Companies that issue such securities are often highly leveraged and may not have available to them more traditional methods of financing. Hedge funds attempt to correctly evaluate the value of these assets and hedge their "long" or "short" positions either directly or through credit default swaps. A hedge fund may elect to trade on this opportunity. In order to do so, it may engage in fundamental credit analysis based on various matters determining corporate cash flows, such as measures of operating performance, balance sheet structure and industry conditions, to ascertain the current or potential ability of a corporation to service and repay debt. Its investing strategy may then be to identify value in the underlying assets or credit obligations of this corporation, in terms of cash flows and enterprise value relative to the hierarchy and other features of claims in its capital structure. It may also attempt to earn current income that an investment in obligations of such a corporation may afford, and to seek a means ultimately to realize the value of the investment through exit (and realize capital gains). a) Timing: The hedge fund may seek to commit capital based on a thorough understanding of the investment opportunity. For example, in stressed or distressed opportunities, it may tend to invest in the late stage of recovery where obligations still trade at a discount to their perceived fundamental value, but the causes of stress or distress are already known and there may be indications that these problems are being resolved. This approach may forego potential gains from investing at an earlier stage, but reduces risk as it allows for a more confident assessment of risk and return. b) Scaling Positions: In a similar fashion, it may typically increase the size of its investment in the corporation s obligations over time as it gains a better understanding of the underlying financial condition of the corporation and the manner in which its obligations trade in the market. c) Seniority: Once a decision to invest in the corporation has been made, the hedge fund may assess where in the capital structure to invest. Often, although not always, the initial investment will be made in obligations that are relatively senior in a corporation s capital structure because such obligations have stronger covenant protection and a priority claim on assets relative to more junior obligations. Over time, the hedge fund may invest in obligations that are less senior in the capital structure to capture further riskadjusted returns. d) Short Selling: If the opportunity presents itself, the hedge fund may choose to "short" either a company s security as a whole, or "short" securities in one part of a company s capital structure, either as a hedge or as a source of incremental return. It may also enter into "short" sales and derivative transactions in situations where investments are overvalued and have a high probability of declining in value. In addition, it may use derivatives such as credit default swaps as a substitute for actual "long" or "short" positions. 6

29 UBS Alternative Investments 25 January 2011 Credit Risk and Market Risk are Interconnected Credit hedge fund managers invest in both public and private non-investment grade and non-rated securities, including, leveraged loans, high yield bonds, distressed securities, second lien loans, mezzanine securities and credit derivatives. As seen earlier, these hedge funds seek to identify undervalued securities, based on either earnings or underlying asset value that have been overlooked, or misunderstood by the market. However, it is important to keep in mind that credit risks and market risks, though often considered separately, are in fact intimately related. This is best seen when considering debt securities such as corporate bonds. For a hold-to-maturity investor, the only risk that really matters is credit risk, i.e. whether or not the issuer defaults at some point in time prior to maturity. However, for any shorter term-oriented investor, or more generally anyone who may sell the corporate bond before maturity, credit risk translates into market risk. Indeed, if after the bond purchase the issuer s credit quality deteriorates, this will be reflected in a decline in the bonds price and an increase in its credit spread. Therefore, a default needn t actually occur. To have a price effect and therefore market risk it is enough for the likelihood of a default to changes over time. Hedge fund trading strategies often go a step further in exploiting the interrelation between credit and market risk. After formally examining fundamental value and market observed pricing interrelationships between credit instruments and equity or equity based options on the same issuer, hedge funds can often arbitrage mispricing. This is illustrated below in two instances: first, convertible securities, second capital structure arbitrage. Example: The case of Convertible Securities A convertible security is a bond that may be converted into or exchanged for a specified amount of common stock within a particular period of time at a specified price or formula. A convertible security entitles its holder to receive interest that is generally paid or accrued on debt or until it matures or is redeemed or converted. They have unique investment characteristics in that they generally I. have higher yields than common stocks, but lower yields than comparable non-convertible securities, II. are less subject to fluctuation in value than the underlying common stock due to their fixed-income characteristics and III. provide the potential for capital appreciation if the market price of the underlying common stock increases. The value of a convertible security is a function of its "investment value" (determined by its yield in comparison with the yields of other securities of comparable maturity and quality that do not have a conversion privilege) and its "conversion value" (the security's worth, at market value, if converted into the underlying common stock). The investment value of a convertible security is influenced by changes in interest rates, with investment value declining as interest rates increase and increasing as interest rates decline. The credit standing of the issuer and other factors may also have an effect on the convertible security's investment value. The conversion value of a convertible security is determined by the market price of the underlying common stock. If the conversion value is low relative to the investment value, the price of the convertible security is governed principally by its investment value. To the extent the market price of the underlying common stock approaches or exceeds the conversion price, the price of the convertible security will be increasingly influenced by its conversion value. A convertible security generally will sell at a premium over its conversion value by the extent to which investors place value on the right to acquire the underlying common stock while holding a fixed-income security. Generally, the amount of the premium decreases as the convertible security approaches maturity. 7

30 UBS Alternative Investments 25 January 2011 Hedge fund managers, who understand the credit and market risk components of a convertible security, are able to arbitrage temporary mispricing. Example: The case of Capital Structure Arbitrage Yet another example of how credit risk and market risk interact is in a strategy called Capital Structure Arbitrage. The success of this strategy depends on the ability of a hedge fund manager to identify and exploit the relationships between movements in different securities and instruments within an issuer's capital structure (e.g., bank debt, convertible and nonconvertible senior and subordinated debt and preferred and common stock). Naturally this strategy is not devoid of loss potential of course, identification and exploitation of these opportunities involves uncertainty. In the event that the perceived pricing inefficiencies underlying an issuer's securities were to fail to materialize, as expected by a hedge fund manager, the trade breaks down and such funds incur loss. Once again, hedge fund managers, who understand the credit and market risk components of a firm s capital structure, are able to arbitrage temporary mispricing. General Trading Techniques As highlighted earlier in Part 1 of this series, there are three primary benefits of including hedge funds in portfolios: Diversification low correlations with traditional asset classes may result in improved portfolio stability. Tailored portfolios an ability to be tailored to meet the investor s needs, thereby delivering very specific risk/return tradeoffs. Market access offer the potential to more efficiently access certain markets and asset classes. These advantages accrue in part due to the flexible trading techniques employed by hedge funds. Popular techniques employed include leveraging, short selling, hedging and arbitrage. Leveraging This involves borrowing money to increase the effective size of the portfolio, or purchasing securities on margin, or synthetically gaining exposure through futures or options contracts For traditional mutual funds, leverage is generally not allowed or is limited. But hedge fund returns often rely heavily on leverage. During periods in which the fund's portfolio is leveraged, fluctuations in the market value of the portfolio will have a significant effect in relation to an investors' capital. When the return of the underlying asset is higher than the borrowing rate, leverage offers a much higher return than the underlying asset. But leverage also amplifies the risk of the hedge fund. When the return of the underlying asset is lower than the borrowing rate, investors suffer a loss on the leveraged position. Moreover, losses in the underlying asset are amplified with leverage. The optimal use of leverage in the portfolio is usually a function of the market conditions that the fund is experiencing. In trending markets, a hedge fund manager that picks the right market direction will see returns enhanced by leverage, while losses will be amplified if the market direction is chosen incorrectly. What is often less well understood is that is sideway markets, leverage will actually reduce returns relative to a comparable unleveraged strategy. Hedge fund managers are therefore more likely to rely on leverage if they believe they have spotted an emerging market trend. 8

31 UBS Alternative Investments 25 January 2011 Short Selling Short selling involves the sale of a security not owned by the seller; a technique used to take advantage of an anticipated price decline. To execute a short sale, the seller borrows securities from a third party in order to make delivery to the purchaser. After some time, the seller returns the borrowed securities to the lender by purchasing the securities in the open market. If, at this later date, the seller can buy that security back at a lower price, a profit results. If the price rises, however, a loss results. It is an inherently risky strategy since the most one can make is the amount received when the securities are sold short, yet the loss potential is unlimited. But in hedge funds, a short position is sometimes used to reduce the risk of long position with similar underlying assets. So for hedge funds, short selling can be used as a hedging technique rather than just something for speculation (see below). Short selling, when used effectively, directly and reliably, reduces risk when added to a net long stock portfolio. An investment manager shorts a stock when he or she believes the stock price will decline or to hedge a long position. A short position has the inverse return characteristics of a long stock position, i.e., the two are negatively correlated, which makes shorting an excellent portfolio risk reduction tool, as well as a potential source of investment profit. Hedging Hedging is essentially a defensive strategy to mitigate the risk of loss to capital. Hedging can be likened to purchasing insurance against the likelihood of an unfavorable event. Depending on the type of risk exposure created by the investment strategy, different types of risk must be hedged, for example currency risk, interest rate risk, political risk, market risk, company risk. For each type of risk, certain hedging techniques and instruments are appropriate. Portfolios tend to be hedged both through systematic or market hedges (typically S&P 500 puts or short positions in exchange-traded funds) and through direct hedges. These hedges can be sector hedges (shorting a basket of comparable company securities) or more direct pair trades (shorting an overvalued comparable company). Hedge fund managers also use options to limit potential downside in a trade. Hedging against a decline in the value of a portfolio position does not eliminate fluctuations in the values of portfolio positions or prevent losses if the values of such positions decline. However, it establishes other positions designed to gain from those same developments, thus, moderating the decline in the combined portfolio positions value. The talented manager is the one who properly analyzes risk and takes positions most efficiently. Hedge funds monitor gross and net exposures, industry concentration, exposure to large capitalization and small/medium capitalization companies, liquidity of individual positions and of the overall portfolio and individual and portfolio level valuations on a regular basis to control risk exposure to any one factor. How the position is established depends on how the security trades (i.e., a position in a large, liquid security may be fully established immediately). The timing of a position may also depend on how the event series unfolds, with positions added to or reduced depending on how the underlying event develops. Positions tend to be closely monitored with particular emphasis on the impact of subsequent information on trades. Positions are typically closed out in one of two ways: the event in question occurs, triggering a sell or selfliquidating the trade. Alternatively, the risk and reward parameters of the trade change such that the fund manager may change his/her view and no longer want to own the position. Many a time these positions are inherently hedged (e.g., risk arbitrage convergence trades) while at other times positions may be hedged via market hedging techniques, such as hedging a long equity market position by using S&P puts. In summary, hedge funds often utilize financial instruments and derivatives, both for investment purposes and for risk management purposes in order to: 9

32 UBS Alternative Investments 25 January 2011 I. protect against possible changes in the market value of their investment portfolios resulting from fluctuations in the securities markets and changes in interest rates; II. protect unrealized gains in their investment portfolio; III. facilitate the sale of investments; IV. enhance or preserve returns, spreads or gains on any investment in the portfolio; V. hedge the interest rate or currency exchange rate on liabilities or assets; or VI. protect against any increase in the price of securities they anticipate purchasing at a later date. The success of a fund's hedging strategy will depend upon the ability to correctly assess the degree of correlation between the performance of the instruments used in the hedging strategy and the performance of the portfolio investments being hedged. Since the characteristics of many securities change, as markets change or time passes, the success of a hedge will be subject to the ability to continually recalculate, readjust and execute hedges in an efficient and timely manner. Arbitrage Arbitrage strategies attempt to exploit temporary price inefficiencies or discrepancies between securities or markets. The hedge fund manager uses historical relationships between instruments in different markets to predict future trends or movements in price. An example from risk arbitrage is the purchase of equity instruments from a company that is to be acquired by another, and offsetting this with a short sale of the equity instruments of the acquiring company. Hedge fund managers do not just borrow publicly listed stocks; they make use of all kinds of financial instruments. The revolution in financial engineering over the last two decades has generated a wide range of trading tools that they can use to participate in arbitrage opportunities. The range of financial instruments includes exchange traded fixed income and equity instruments, as well as commodity derivatives, fixed income OTC derivatives, credit derivatives, structured and hybrid instruments. Arbitrage opportunities are generally not riskless arbitrage, as the term may suggest i.e. purchasing something at one price and simultaneously selling that at a higher price, generating a profit on the difference. Often, since the underlying assets are related but not exactly the same, generating residue risk which can have an impact on returns. Conclusion Hedge funds are defined both by their investment technique (i.e., use of shorting, leverage, and derivatives) to arbitrage credit and market risks as well as their unique structure (i.e., largely unregulated limited partnerships). Many investors in hedge funds have been rewarded in the past and have the potential to continue to see positive performance provided they are invested with the right managers and in the right trading strategies. These trading strategies are a combination of informed or speculative trades on credit risk and market risk inherent in any financial instrument. Understanding the concepts behind credit risk and market risk is the foundation to understand hedge fund trading strategies, the inherent sources of risks in those strategies and in the manner hedge funds unlock value in trades. 10

33 UBS Alternative Investments 25 January 2011 Note on Investor Suitability Equity Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Small Cap Risk: The value of the portfolio will fluctuate based on the value of the underlying securities. Small-cap stocks may be subject to a higher degree of risk than more established companies' securities, including higher volatility. International Risk: The value of the portfolio will fluctuate based on the value of the underlying securities. Foreign investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Fixed income: The value of the portfolio will fluctuate based on the value of the underlying securities. Two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Mortgage-backed securities: Mortgage-backed securities are subject to prepayment risk and may be sensitive to changes in prevailing interest rates. When interest rates rise, the value of fixed income securities generally declines. Collateralized mortgage obligation (CMO): CMO s yield and average life will fluctuate depending of the actual rate at which mortgage holders prepay the mortgages underlying the CMO and changes in current interest rates. High-Yield Securities Risk: High-yield securities carry a high degree of risk. High-yield bonds (also known as "junk bonds") are subject to greater loss of principal and interest, including default risk, than investment grade bonds. Therefore, their prices may be more volatile. Bonds rated 'BB' (lower medium grade); 'B' (low grade), 'CCC' (poor quality), 'CC' (most speculative) and 'D' (default) are regarded as having significant speculative characteristics. Municipal Securities Risk: This strategy invests in municipal securities. Municipal securities are subject to the risk that legislative changes and local and business developments may adversely affect the yield or value of the strategy's investments in such securities. An investment in any municipal portfolio should be made with an understanding of the risks involved in investing in municipal bonds, such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. Clients should contact their tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on state of residence. Preferred Securities Risk: There are special risks associated with an investment in preferred securities, including credit risk, interest rate fluctuations, US Government sponsored securities risk, sector concentration risk and real estate securities risk. 11

34 UBS Alternative Investments 16 February 2011 Hedge Fund Education Series Part 3: Asset Characteristics of Hedge Funds Reports in this series Highlights Page Part 1: What are Hedge Funds? Part 2: Inside the Black Box Part 3: Asset Characteristics of Hedge Funds Returns 1 Biases in Interpreting Benchmark Returns 3 Performance Persistence 4 Correlations 6 Distributional Properties 7 Skewness 8 Kurtosis 9 Conclusion 10 Part 4: Important Hedge Fund Strategies Part 5: Implementing a Hedge Fund Portfolio As discussed in part 1 of this series, hedge funds are considered an alternative asset class, in contrast with traditional investments such as stock and bonds. One of the reasons to view hedge funds in a somewhat different light than bread and butter asset classes is the differing asset characteristics that hedge funds exhibit. This installment of the hedge fund series focuses on these performance characteristics, providing insights into returns and correlations, but also drilling into additional distributional aspects such as skewness and kurtosis (fat tails). Returns UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. The main reason why some hedge funds have attracted so much capital and investor interest has been their track record of attractive absolute returns. Although claims of superior performance by a few managers are cited in the financial press, the question of whether the industry as a whole performs well is still open. One can think of hedge fund returns as a combination of exposure to macro factors (economic exposure or beta ), fund-level elements (fees structure, trade implementation capabilities) as well as manager skill (or alpha ) in processing security or market specific information. 1 The excess returns that some hedge funds exhibit are a result of certain trading advantages. These advantages can include cheaper trading costs (due to large volumes and turnover), better market access, superior information processing abilities, as well as other structural and statutory benefits. These trading advantages are not new within financial markets. In fact they have existed for decades. However, prior to the emergence of hedge funds, they were in the exclusive domain of large financial institutions that 1

35 UBS Alternative Investments 16 February 2011 traditionally supplied liquidity and speculative capital to the market place. Another driver of inherent excess returns is that most of the specialized activities conducted within hedge funds require a substantial research infrastructure. It is, in most cases, uneconomic for traditional mutual funds to build similar research and trade execution capabilities given the substantially lower fees they charge relative to hedge funds. Figure 1: Hedge Fund Performance Versus Other Asset Classes (from 12/31/1995 to 12/31/2010) Total return indices since 1995 (=100) S&P 500 BarCap US Agg Bond index HFRI Fund Weighted Composite Cash (3-month LIBOR) Source: Bloomberg. Past performance is not indicative of future results. Indexes are for illustrative purposes only. Indexes are not available for direct investment. Please see the endnotes for important disclosure about indexes. According to Hedge Fund Research, Hedge Funds, as an aggregate industry, have generated around 12% annual returns over the last 20 years. Unlike in traditional investment managers, such as those active in the large cap equity space, there is huge dispersion of returns between hedge funds that perform well and those that do not. The performance of individual hedge funds may therefore be very different from the overall hedge fund index. In addition to wide differences in performance, there is another important consideration - the difference in volatilities between an individual fund and the index. Because the correlation of returns among hedge funds included within a strategy index is often low, diversification across the index constituent s results in volatility well below that of the average hedge fund. Therefore, an investment in a single hedge fund might well generate significantly different results, and in particular higher volatility, than the index portfolio performance would suggest. 2

36 UBS Alternative Investments 16 February 2011 Biases in Interpreting Benchmark Returns Another caveat in observing the numbers in Figure 1 is that hedge fund industry returns vary widely depending upon which commercial database one considers. Hedge Fund Research (HFR) and Eureka Hedge are popular industry databases (there are around 6 more) and there is little consensus between them. Moreover, all hedge fund databases are biased to some extent, which distorts the picture on true performance. Some common biases are worth highlighting: Selection bias/reporting bias Since hedge funds self report their returns data, there is a risk that reporting hedge funds may not be representative of all existing hedge funds. For instance, it has been argued that among funds that are raising capital, those with significant excess returns or good performance are likely to report their results to data base vendors for marketing purposes. Funds that have not performed well have no incentive to report their returns. This selection bias intuitively leads to an overestimate of true returns in the industry. Conversely, successful hedge fund managers who are not raising capital have no incentive to report returns to database vendors, as this would only improve the benchmarks against which they are compared. This bias works in the opposite direction leading to an underestimation of true returns. Survivorship bias Hedge funds, because of poor performance frequently close down when they are unable to recover losses and meet hurdle rates of returns described as the high water mark". Database vendors do not account for funds that go out of business because of poor performance. They report on funds that are in business and are reporting returns. This bias leads industry returns to be overstated. Figure 2: Around 50% of hedge funds have been in existence for less than 5 years Estimated Fund Age, Q % 11.6% 33.6% 9.7% 17.6% 21.1% <1 Yr 1 to <2 Yrs 2 to <3 Yrs 3 to <5 Yrs 5 to <7 Yrs 7 Yrs + Source: HFR Industry Reports, HFR, Inc., 3

37 UBS Alternative Investments 6 January 2011 Instant History Bias Many hedge funds start off small, often with in-house or proprietary capital, and build a track record of success. Those that succeed in creating good performance go on to market themselves to outside investors while the poor performers fold up. Once they are able to raise capital from external investors, managers begin reporting their returns to database vendors who back fill performance numbers creating an instant history bias. This too leads to overestimating returns. Stale Pricing Bias Hedge funds often invest in illiquid and complex securities that are hard to mark-tomarket as they may be thinly traded or because a market for them may temporarily just not exist. For valuation purposes, in such cases, managers may either use the last reported transaction price or an estimate of the current market price which may be a lagging indicator of real value. The result of stale pricing is serial correlation reported returns over time, which reduces reported volatility. This is more pronounced in illiquid strategies such as convertible arbitrage and in distressed debt given the longer time lapse in markingto-market illiquid securities in those areas. By underestimating true volatility, hedge fund benchmark indices over-estimate risk adjusted returns. The cumulative effect of these biases is not known with certainty, though attempts to estimate them have been made in academia. Performance Persistence While there is definite evidence of superior performance over long periods of time, for most individual strategies the results are not stable over shorter periods of time. In other words there is very little persistence in performance for best and worst performing strategies, and at best very weak evidence for middle deciles. Figure 3: Returns by Strategy Type HFRI Indices Annual Investment Returns HFRI Emerging HFRI ED: HFRI RV: BarCap US HFRI Emerging HFRI ED: HFRI Emerging HFRI Emerging HFRI Emerging BarCap US HFRI RV: S&P 500 Markets Merger Arb ConvertArb Agg Markets Distressed Markets Markets Markets Agg ConvertArb 15.06% 55.86% 18.02% 13.37% 10.25% 39.36% 18.89% 21.04% 24.26% 24.92% 5.24% 60.17% S&P % HFRI Equity Hedge 15.98% BarCap US Agg 8.69% HFRI EH: Eq Mrkt Ntrl 8.30% HFRI RV: ConvertArb 7.77% HFRI ED: Merger Arb 7.23% HFRI Macro 6.19% HFRI Relative Value 2.81% HFRI Fund Wghtd Comp 2.62% HFRI Event- Driven 1.70% HFRI ED: Distressed -4.23% HFRI FOF Composite -5.11% HFRI Emerging Markets % HFRI Equity Hedge 44.22% HFRI Fund Wghtd Comp 31.29% HFRI FOF Composite 26.47% HFRI Event- Driven 24.33% S&P % HFRI Macro 17.62% HFRI ED: Distressed 16.94% HFRI Relative Value 14.73% HFRI RV: ConvertArb 14.41% HFRI ED: Merger Arb 14.34% HFRI EH: Eq Mrkt Ntrl 7.09% BarCap US Agg -0.82% HFRI EH: Eq Mrkt Ntrl 14.56% HFRI RV: ConvertArb 14.50% HFRI Relative Value 13.41% BarCap US Agg 11.63% HFRI Equity Hedge9.09% HFRI Event- Driven 6.74% HFRI Fund Wghtd Comp 4.98% HFRI FOF Composite 4.07% HFRI ED: Distressed 2.78% HFRI Macro 1.97% S&P % HFRI Emerging Markets % HFRI ED: Distressed 13.28% HFRI Event- Driven 12.18% HFRI Emerging Markets 10.36% HFRI Relative Value 8.92% BarCap US Agg 8.44% HFRI Macro 6.87% HFRI EH: Eq Mrkt Ntrl 6.71% HFRI Fund Wghtd Comp 4.62% HFRI FOF Composite 2.80% HFRI ED: Merger Arb 2.76% HFRI Equity Hedge 0.40% S&P % HFRI RV: ConvertArb 9.05% HFRI Macro 7.44% HFRI Relative Value 5.44% HFRI ED: Distressed 5.28% HFRI Emerging Markets 3.70% HFRI FOF Composite 1.02% HFRI EH: Eq Mrkt Ntrl 0.98% HFRI ED: Merger Arb -0.87% HFRI Fund Wghtd Comp -1.45% HFRI Event- Driven -4.30% HFRI Equity Hedge -4.71% S&P % HFRI ED: Distressed 29.56% S&P % HFRI Event- Driven 25.33% HFRI Macro 21.42% HFRI Equity Hedge 20.54% HFRI Fund Wghtd Comp 19.55% HFRI FOF Composite 11.61% HFRI RV: ConvertArb 9.93% HFRI EH: Eq Mrkt Ntrl 2.44% HFRI Relative Value 9.72% HFRI ED: Merger Arb 7.47% BarCap US Agg 4.10% HFRI Emerging Markets 18.42% HFRI Event- Driven 15.01% S&P % HFRI Fund Wghtd Comp 9.03% HFRI Equity Hedge 7.68% HFRI FOF Composite 6.86% HFRI Relative Value 5.58% HFRI Macro 4.63% BarCap US Agg 4.34% HFRI EH: Eq Mrkt Ntrl 4.15% HFRI ED: Merger Arb 4.08% HFRI RV: ConvertArb 1.18% HFRI Equity Hedge 10.60% HFRI Fund Wghtd Comp 9.30% HFRI ED: Distressed 8.27% HFRI FOF Composite 7.49% HFRI Event- Driven 7.29% HFRI Macro 6.79% HFRI ED: Merger Arb 6.25% HFRI EH: Eq Mrkt Ntrl 6.22% HFRI Relative Value 6.02% S&P % BarCap US Agg 2.43% HFRI RV: ConvertArb- 1.86% HFRI ED: Distressed 15.94% S&P % HFRI Event- Driven 15.33% HFRI ED: Merger Arb 14.24% HFRI Fund Wghtd Comp 12.89% HFRI Relative Value 12.37% HFRI RV: ConvertArb 12.17% HFRI Equity Hedge 11.71% HFRI FOF Composite 10.39% HFRI Macro 8.15% HFRI EH: Eq Mrkt Ntrl 7.32% BarCap US Agg 4.33% HFRI Macro 11.11% HFRI Equity Hedge 10.48% HFRI FOF Composite 10.25% HFRI Fund Wghtd Comp 9.96% HFRI Relative Value 8.94% HFRI ED: Merger Arb 7.05% BarCap US Agg 6.97% HFRI Event- Driven 6.61% S&P % HFRI RV: ConvertArb 5.33% HFRI EH: Eq Mrkt Ntrl 5.29% HFRI ED: Distressed 5.08% HFRI Macro 4.83% HFRI ED: Merger Arb -5.37% HFRI EH: Eq Mrkt Ntrl -5.92% HFRI Relative Value % HFRI Fund Wghtd Comp % HFRI FOF Composite % HFRI Event- Driven % HFRI ED: Distressed % HFRI Equity Hedge % HFRI RV: ConvertArb % S&P % HFRI Emerging Markets % HFRI Emerging Markets 40.25% HFRI ED: Distressed 28.14% S&P % HFRI Relative Value 25.81% HFRI Event- Driven 25.04% HFRI Equity Hedge 24.57% HFRI Fund Wghtd Comp 19.98% HFRI ED: Merger Arb 11.65% HFRI FOF Composite 11.47% BarCap US Agg 5.93% HFRI Macro 4.34% HFRI EH: Eq Mrkt Ntrl 1.43% HFRI RV: ConvertArb 13.07% HFRI Emerging Markets 11.96% HFRI Relative Value 11.73% HFRI Event- Driven 11.53% HFRI ED: Distressed 11.26% HFRI Equity Hedge 10.58% HFRI Fund Wghtd Comp 10.49% HFRI Macro 8.61% BarCap US Agg 6.54% HFRI FOF Composite 5.60% HFRI ED: Merger Arb 4.60% HFRI EH: Eq Mrkt Ntrl 3.16% Source: HFR Industry Reports, HFR, Inc., Past performance is not indicative of future results. Indexes are for illustrative purposes only. Indexes are not available for direct investment. Please see the endnotes for important disclosure about indexes. 4

38 UBS Alternative Investments 16 February 2011 After analyzing the data in Figure 3 to determine the strategy transition matrix for the period, we find that there is just a 33% probability that a strategy that was in the top quartile in a given year would remain in the top quartile in the next year. Moreover, the standard deviation within top and bottom deciles is the greatest of all, indicating more dispersion of returns within the best and worst performing strategies. This is described in Figure 4. This highlights the importance of strategy selection. Figure 4: Strategy Transition Matrix Highlights Importance of Strategy Selection Percentage of strategies that were in quartile X (column heading) and in quartile Y (row heading) in the following month Top quarter Second quarter Third quarter Fourth quarter Top quarter 37% 23% 18% 22% Second quarter 23% 30% 28% 20% Third quarter 16% 29% 34% 21% Fourth quarter 24% 18% 21% 37% Source: UBS WMR, HFR Industry Reports, HFR, Inc., from December 1989 to July 2010 Figure 5: Hedge Fund Performance: Last 5 Years (from 12/31/2005 to 12/31/2010) Annualized, in % Equity Hedge EH: Energy/Basic Materials EH: Eq Mrkt Ntrl EH: Quant Drctnl EH: Short Bias EH: Tech/HC Event-Driven ED: Distressed ED: Merg Arb ED: Prvte/RegD Macro Macro: Sys Div Relative Value RV: FI- Asset Backed RV: FI- Conv Arb RV: FI-Corp RV: Multi-Strat RV: Yield Alts Fund Weighted Comp FOF Comp Emrgng Mrkts (Total) EM: Asia ex-japan EM: Global EM: LatAm EM: Russia BarCap US Agg Bond index S&P 500 Source: HFR Industry Reports, HFR, Inc., Past performance is not indicative of future results. Indexes are for illustrative purposes only. Indexes are not available for direct investment. Please see the endnotes for important disclosure about indexes. 5

39 UBS Alternative Investments 16 February 2011 Correlations As seen in Figure 6, there is a variety of strategies that display relatively low correlation coefficients (less than 0.5) with stocks and bonds, as well as amongst each other. Therefore, carefully combining these strategies can contribute to creating a more stable portfolio. We note that some hedge fund strategies, especially those that are equity market-based, do exhibit a higher positive correlation with the stock market. However there are others such as convertible arbitrage and equity market neutral which are less correlated. Within fixed income strategies, the degree correlation with the bond market is generally low. Interestingly, and this is dependent on the time period studied, with the exception of equity market neutral, most hedge fund strategies tend to be more highly correlated to each other than one would expect - perhaps reflecting exposure to the same set of systematic underlying factors. Figure 6: Long-term Correlations Correlation of monthly returns since 1996 S&P 500 BarCap US Agg Fund Weighted Comp FOF Comp Equity Hedge EH: Energy/Basic Materia EH: Eq Mrkt Ntrl EH: Quant Drctnl EH: Short Bias EH: Tech/HC Event-Driven S&P BarCap US Agg Fund Weighted Comp FOF Comp Equity Hedge EH: Energy/Basic Materials EH: Eq Mrkt Ntrl EH: Quant Drctnl EH: Short Bias EH: Tech/HC Event-Driven ED: Distressed ED: Merg Arb ED: Prvte/RegD Macro Macro Sys Div Relative Value RV: FI- Asset Backed RV: FI ConvArb RV: FI-Corp RV: Multi-Strat RV: Yield Alts Emrgng Mrkts (Total) EM: Asia ex-japan EM: Global EM: LatAm EM: Russia Source: HFR Industry Reports, HFR, Inc., Past performance is not indicative of future results. Indexes are for illustrative purposes only. Indexes are not available for direct investment. Please see the endnotes for important disclosure about indexes. ED: Distressed ED: Merg Arb ED: Prvte/RegD Macro Macro Sys Div Relative Value RV: FI- Asset Backed RV: FI ConvArb RV: FI-Corp RV: Multi-Strat RV: Yield Alts Emrgng Mrkts (Total) EM: Asia ex-japan EM: Global EM: LatAm EM: Russia Hedge fund strategies do not have stable correlations to broader market movements and neither do they have predictable short term correlations to each other. Having said this, there are certain strategies that provide valuable diversification during periods of general market stress. As Figure 7 indicates, the equity market neutral strategy was just 13% correlated with the S&P 500 during the financial crisis. The Fund of Funds market defensive index (not shown above) was in fact negatively correlated with the S&P 500 something rather remarkable given that correlations converged across almost all asset classes. Likewise, the Macro index was slightly negatively correlated with the S&P 500 during the financial crisis. 6

40 UBS Alternative Investments 16 February 2011 Figure 7: Correlations during Financial Crisis Correlation of monthly returns: July 2007 to March 2009 S&P 500 BarCap US Agg Fund Weighted Comp FOF Comp Equity Hedge EH: Energy/Basic Mater EH: Eq Mrkt Ntrl EH: Quant Drctnl EH: Short Bias EH: Tech/HC Event-Driven S&P BarCap US Agg Fund Weighted Comp FOF Comp Equity Hedge EH: Energy/Basic Materials EH: Eq Mrkt Ntrl EH: Quant Drctnl EH: Short Bias EH: Tech/HC Event-Driven ED: Distressed ED: Merg Arb ED: Prvte/RegD Macro Macro Sys Div Relative Value RV: FI- Asset Backed RV: FI ConvArb RV: FI-Corp RV: Multi-Strat RV: Yield Alts Emrgng Mrkts (Total) EM: Asia ex-japan EM: Global EM: LatAm EM: Russia Source: HFR Industry Reports, HFR, Inc., Past performance is not indicative of future results. Indexes are for illustrative purposes only. Indexes are not available for direct investment. Please see the endnotes for important disclosure about indexes. ED: Distressed ED: Merg Arb ED: Prvte/RegD Macro Macro Sys Div Relative Value RV: FI- Asset Backed RV: FI ConvArb RV: FI-Corp RV: Multi-Strat RV: Yield Alts Emrgng Mrkts (Total) EM: Asia ex-japan EM: Global EM: LatAm EM: Russia Distributional Properties A concern in hedge fund performance evaluation has been the non-standard distributional properties of their returns. Hedge fund returns offer relatively high means and low variances, but they also tend to expose investors to skewness and kurtosis which are undesirable properties. The historical returns for stocks are typically close to normally distributed, exhibiting a bell-shaped curve. By contrast, hedge fund strategies typically exhibit asymmetric distributions and higher probability of extreme outcomes. In order to interpret the numbers in Figure 8, we need to understand the concepts of "skewness" and "kurtosis". These are statistical measures that describe the distribution of returns earned from an investment in an asset class and are particularly relevant to hedge fund. 7

41 UBS Alternative Investments 16 February 2011 Figure 8: Distribution Properties Based on monthly annualized returns since 12/31/1995 through 12/31/2010 Standard Mean Deviation Skewness Kurtosis Fund Weighted Composite Fund of Fund Composite Equity Hedge EH: Energy/Basic Materials EH: Equity Market Neutral EH: Quant Directional EH: Short Bias EH: Tech/HC Event-Driven ED: Distressed ED: Merger Arbitrage ED: Private Issue / Regulated Macro Macro Systematic Diversified Relative Value RV: FI- Asset Backed RV: FI Convertible Arbitrage RV: FI-Corporate RV: Multi-Strategy RV: Yield Alternatives Emerging Markets (Total) EM: Asia ex-japan EM: Global EM: LatAm EM: Russia Source: Bloomberg, HFR Industry Reports, HFR, Inc., Past performance is not indicative of future results. Indexes are for illustrative purposes only. Indexes are not available for direct investment. Please see the endnotes for important disclosure about indexes. Skewness A normal (bell-shaped) distribution of returns has no skewness because it is a symmetric distribution as depicted in Figure 9. Many traditional asset class returns have very little skewness i.e. their returns tend to be symmetrically clustered around a certain expected value or mean return. Figure 9: Normal Distribution NORMAL DISTRIBUTION X-Axis = Returns Y-Axis = Frequency MEAN VOLATILITY Hedge fund strategies, however exhibit, skewed returns. Skewness is a measure of the shape of a distribution. It indicates the degree of asymmetry in a distribution (a range of returns). Skewed distributions have more values to one side of the peak or most likely value one tail is longer than the other. A skewness of 0 indicates a symmetric distribution, while a negative skewness means the distribution is skewed to the left. Positive skewness indicates a skew to the right. A normal distribution has a skewness equal to 0. A negative skew as seen in Figure 10 indicates that the mean of the distribution is to the left of (less than) the median of the distribution. Figure 10: Negative Skewness in Returns NEGATIVE SKEW TAIL RISK Source: UBS Alternative Investments MEAN This means that there are more frequent large return observations to the left of the distribution (negative returns) and there are more small and mid-range positive return observations to the right of the distribution. In other words, large negative outlying returns occur more frequently than large positive outlying returns, indicating a bias to the downside. This is an undesirable property. Strategies that have historically exhibited negative skew indicate that there is a higher probability of a significant loss taking place. This is especially true for the convertible arbitrage, risk arbitrage, and distressed securities indices. Source: UBS Alternative Investments 8

42 UBS Alternative Investments 16 February 2011 A positive skew indicates the reverse of a negative skew. It indicates that the mean of the distribution is to the right of the median and that there are more frequent large positive returns than there are large negative returns. A positive skew demonstrates a bias to the upside, which is a good thing. Hedge fund strategies that are generally positively skewed include long/short equity and global macro. Kurtosis Kurtosis is measured relative to a normal, bell-shaped distribution. A positive value for kurtosis indicates a fatter distribution with greater dispersion around the mean with "fatter" than normal tails. It implies a higher probability of extreme outcomes (or large surprises) than would be expected for a normal distribution, regardless of the direction of such deviations. Conversely, a negative value indicates a more compact distribution of returns values with "thinner" than normal tails. When an asset exhibits non-zero skeweness and kurtosis, not taking account of this will lead to an incomplete assessment of risk. To illustrate this we extend mean variance analysis, 3 replacing variance by a broader risk concept such as VaR (Value at risk). 4 If as in figure 11 we plot an efficient frontier in Mean VaR space, ignoring skeweness and kurtosis, this will lead to underestimating true risk. The points on the efficient frontier without skewness and kurtosis have a higher expected return at each level of risk (VaR) as compared to the points on the True efficient frontier with skewness and kurtosis. Figure 11: The Effects of Skewness and Kurtosis Shift the Estimated Efficient Frontier to the Bottom-Left Skewness (S) and Kurtosis (K) Historic monthly returns annual Annual return Annual return portfolio adjusted for S + K efficient frontier without consideration of S + K True efficient frontier with consideration of S + K Source: UBS Alternative Investments, stylized illustration Normal and modified VaR 9

43 UBS Alternative Investments 16 February 2011 Conclusion End Notes Acknowledging the special distributional properties of hedge fund returns is essential to investing in the asset class. In particular, hedge fund returns are nonnormally distributed and exhibit negative skewness and positive excess kurtosis. Some strategies such as credit and distressed securities have the highest degree of non normality. For instance, credit risk distributions are generally exposed to significant downside risk. This risk is embodied in the form of credit events such as downgrades, defaults, and bankruptcies - the return distribution for high-yield debt is distinctly non-normal and has a negative skew value. This indicates that the distribution of returns associated with credit-risky high yield debt assets have larger negative returns than they do large positive returns; there is a bias to the downside. In addition, they have a positive value of kurtosis. This indicates that credit risk assets are exposed to large negative outlier events. Hedge funds non-normal return distributions have implications for performance measurement. Together, a negative skew value and a large kurtosis value indicate significant, albeit rare, downside risk. The Sharpe Ratio, 2 a very standard performance measurement for traditional assets, is unsuitable for hedge fund performance evaluation since it only looks at the mean and standard deviation. The Sharpe Ratio will systematically overstate true hedge fund performance relative to that of the standard market indices. Neglecting hedge funds, skewness and kurtosis properties, and using the Sharpe Ratio alone will, in many cases, overstate true risk adjusted performance. 1 Hedge funds use many public and private available sources of market information, including but not limited to: major news sources, screen-based news and trading systems, trade publications, Wall Street research, information from lawyers, bankers, accountants and other professionals, and information from the fund manager's proprietary network of relationships. 2 The Sharpe Ratio is the average return, less the riskfree return, divided by the standard deviation of return. The ratio measures the relationship of reward to risk in an investment strategy. When returns are normally distributed as in a bell curve (traditional) the higher the ratio the safer the strategy. 3 Mean variance analysis is a tool of portfolio selection that constructs a portfolio of securities by focusing on the resulting mean expected return and the expected variance of the portfolio. Portfolios are represented in a mean-variance plane. The efficient frontier line represents the set of portfolios with the highest expected return for each given risk level (or lowest risk for each given return level). Those portfolios are called "efficient" portfolios. 4 VaR (Value at Risk) is a probabilistic technique for estimating the "maximum" loss that might arise on a portfolio of risk positions given historical volatilities of underlying rates and prices and their correlations. Maximum in this context is never the worst possible loss but only the worst loss within a given level of confidence, often a 99% worst case. 10

44 UBS Alternative Investments 16 February 2011 Appendix The use of indexes is for illustrative purposes only. Some indexes are unmanaged, are not available for direct investment and are not subject to management fees and other fees and expenses. Information about the index is derived from sources that we believe to be reliable, but we have not independently verified them and we do not warrant as to its accuracy or completeness. Fund Weighted Composite A global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 million under management or a 12-month track record of active performance. The Index does not include Funds of Hedge Funds. Fund of Fund Composite Invests with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers. Equity Hedge Maintains positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. Typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short. EH: Energy/Basic Materials Designed to identify opportunities in securities in specific niche areas of the market in which the Manager maintains a level of expertise which exceeds that of a market generalist in identify companies engaged in the production and procurement of inputs to industrial processes, and implicitly sensitive to the direction of price trends as determined by shifts in supply and demand factors, and implicitly sensitive to the direction of broader economic trends. Typically maintains a primary focus in this area or expect to maintain in excess of 50% of portfolio exposure to these sectors over a various market cycles. EH: Equity Market Neutral Employs sophisticated quantitative techniques of analyzing price data to ascertain information about future price movement and relationships between securities, select securities for purchase and sale. These can include both Factorbased and Statistical Arbitrage/Trading strategies. Factor-based investment strategies include strategies in which the investment thesis is predicated on the systematic analysis of common relationships between securities. In many but not all cases, portfolios are constructed to be neutral to one or multiple variables, such as broader equity markets in dollar or beta terms, and leverage is frequently employed to enhance the return profile of the positions identified. Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high frequency techniques may be employed and trading strategies may also be employed on the basis on technical analysis or opportunistically to exploit new information the investment manager believes has not been fully, completely or accurately discounted into current security prices. Typically maintains characteristic net equity market exposure no greater than 10% long or short. EH: Quantitative Directional Employs sophisticated quantitative analysis of price, other technical and fundamental data to ascertain relationships among securities and to select securities for purchase and sale. These can include both Factor-based and Statistical Arbitrage/Trading strategies. Factor-based investment strategies include strategies in which the investment thesis is predicated on the systematic analysis of common relationships between securities. Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high frequency techniques may be employed and trading strategies may also be employed on the basis on technical analysis or opportunistically to exploit new information the investment manager believes has not been fully, completely or accurately discounted into current security prices. Typically maintains varying levels of net long or short equity market exposure over various market cycles. EH: Short Bias Employs analytical techniques in which the investment thesis is predicated on assessment of the valuation characteristics on the underlying companies with the goal of identifying overvalued companies. Short Biased strategies may vary the investment level or the level of short exposure over market cycles, but the primary distinguishing characteristic is that the manager maintains consistent short exposure and expects to outperform traditional equity managers in declining equity markets. Investment theses may be fundamental or technical in nature and manager has a particular focus, above that of a market generalist, on identification of overvalued companies and would expect to maintain a net short equity position over various market cycles. EH: Technology/Healthcare Designed to identify opportunities in securities in specific niche areas of the market in which the 11

45 UBS Alternative Investments 16 February 2011 Manager maintain a level of expertise which exceeds that of a market generalist in identifying opportunities in companies engaged in all development, production and application of technology, biotechnology and as related to production of pharmaceuticals and healthcare industry. Though some diversity exists as an across sub-strategy, strategies implicitly exhibit some characteristic sensitivity to broader growth trends, or in the case of the latter, developments specific to the healthcare industry. Typically maintains a primary focus in this area or expects to maintain in excess of 50% of portfolio exposure to these sectors over a various market cycles. Event-Driven Maintains positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure. ED: Distressed Focused on corporate fixed income instruments, primarily on corporate credit instruments of companies trading at significant discounts to their value at issuance or obliged (par value) at maturity as a result of either formal bankruptcy proceeding or financial market perception of near term proceedings. Managers are typically actively involved with the management of these companies, frequently involved on creditors committees in negotiating the exchange of securities for alternative obligations, either swaps of debt, equity or hybrid securities. Employ fundamental credit processes focused on valuation and asset coverage of securities of distressed firms; in most cases portfolio exposures are concentrated in instruments which are publicly traded, in some cases actively and in others under reduced liquidity but in general for which a reasonable public market exists. In contrast to Special Situations, Distressed Strategies employ primarily debt (greater than 60%) but also may maintain related equity exposure. ED: Merger Arbitrage Primarily focuses on opportunities in equity and equity related instruments of companies which are currently engaged in a corporate transaction. Merger Arbitrage involves primarily announced transactions, typically with limited or no exposure to situations which pre-, post-date or situations in which no formal announcement is expected to occur. Opportunities are frequently presented in cross border, collared and international transactions which incorporate multiple geographic regulatory institutions, with typically involve minimal exposure to corporate credits. Typically has over 75% of positions in announced transactions over a given market cycle. ED: Private Issue/ Regulation D Employs an investment process primarily focused on opportunities in equity and equity related instruments of companies which are primarily private and illiquid in nature. These most frequently involve realizing an investment premium for holding private obligations or securities for which a reasonably liquid market does not readily exist until such time as a catalyst such as new security issuance or emergence from bankruptcy proceedings occurs. Employs fundamental valuation processes focused on asset coverage of securities of issuer firms, and would expect over a given market cycle to maintain greater than 50% of the portfolio in private securities, including Reg D or PIPE transactions. Macro Trades a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Employs a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant and integral to investment thesis. Macro Systematic Diversified Has investment processes typically as function of mathematical, algorithmic and technical models, with little or no influence of individuals over the portfolio positioning. Designed to identify opportunities in markets exhibiting trending or momentum characteristics across individual instruments or asset classes. Typically employs quantitative processes which focus on statistically robust or technical patterns in the return series of the asset, and typically focus on highly liquid instruments and maintain shorter holding periods than either discretionary or mean reverting strategies. Although some strategies seek to employ counter trend models, strategies benefit most from an environment characterized by persistent, discernable trending behavior. Typically expects to have no greater than 35% of portfolio in either dedicated currency or commodity exposures over a given market cycle. Relative Value Maintains positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Employs a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment 12

46 UBS Alternative Investments 16 February 2011 manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction. RV: Fixed Income-Asset Backed Includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a fixed income instrument backed physical collateral or other financial obligations (loans, mortgages, credit cards) other than those of a specific corporation. Designed to isolate attractive opportunities between a variety of fixed income instruments specifically securitized by collateral commitments which frequently include loans, pools and portfolios of loans, receivables, real estate, mortgage, machinery or other tangible financial commitments. Investment thesis may be predicated on an attractive spread given the nature and quality of the collateral, the liquidity characteristics of the underlying instruments and on issuance and trends in collateralized fixed income instruments, broadly speaking. In many cases, investment managers hedge, limit or offset interest rate exposure in the interest of isolating the risk of the position to strictly the yield disparity of the instrument relative to the lower risk instruments. RV: Fixed Income-Convertible Arbitrage Includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a convertible fixed income instrument. Designed to isolate attractive opportunities between the price of a convertible security and the price of a non-convertible security, typically of the same issuer. Maintains characteristic sensitivities to credit quality the issuer, implied and realized volatility of the underlying instruments, levels of interest rates and the valuation of the issuer s equity, among other more general market and idiosyncratic sensitivities. RV: Fixed Income-Corporate Includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a corporate fixed income instrument. Designed to isolate attractive opportunities between a variety of fixed income instruments, typically realizing an attractive spread between multiple corporate bonds or between a corporate and risk free government bond. Typically involves more general market hedges which may vary in the degree to which they limit fixed income market exposure. This differs from Event Driven: Credit Arbitrage, which typically involves arbitrage positions with little or no net credit market exposure, but are predicated on specific, anticipated idiosyncratic developments. RV: Multi-Strategy Employs an investment thesis is predicated on realization of a spread between related yield instruments in which one or multiple components of the spread contains a fixed income, derivative, equity, real estate, MLP or combination of these or other instruments. Strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. In many cases these strategies may exist as distinct strategies across which a vehicle which allocates directly, or may exist as related strategies over which a single individual or decision making process manages. Not intended to provide broadest-based mass market investors appeal, but are most frequently distinguished from other arbitrage strategies in that they expect to maintain >30% of portfolio exposure in 2 or more strategies meaningfully distinct from each other that are expected to respond to diverse market influences. RV: Yield Alternatives Employs an investment thesis which is predicated on realization of a valuation differential between related instruments in which one or multiple components of the spread contains exposure to Energy Infrastructure most typically achieved through investment in Master Limited Partnerships, Utilities or Power Generation. Strategies are typically fundamentally driven to measure the existing relationship between instruments and identify positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. In contrast to Equity Hedge strategies, the investment thesis is predicated on the yield differential realized from the securities as opposed to directional price appreciation of the underlying securities, and strategies typically contain greater than 50% of portfolio exposure to Energy Infrastructure positions. Emerging Markets (Total) Funds invest, primarily long, in securities of companies or the sovereign debt of developing or 'emerging' countries. Regions include Africa, Asia ex-japan, Latin America, the Middle East and Russia/Eastern Europe. Funds will shift their weightings among these regions according to market conditions and manager perspectives. Emerging Markets: Asia ex-japan Funds focus greater than 50% of their investments in the Asia ex-japan region, which includes China, Korea, Australia, India, Hong Kong and Singapore. Emerging Markets: Global Funds will shift their weightings among a variety of emerging markets regions according to market conditions and manager perspectives. Emerging Markets: Latin America Funds focus greater than 50% of their investments in the Latin American region, which includes Mexico, Central and South America, as well as the nations of the Caribbean. Emerging Markets: Russia Funds focus greater than 50% of their investments in the Russian/Eastern European region, including Turkey. Source: HFR Industry Reports, HFR, Inc., 13

47 UBS Alternative Investments 16 February 2011 Standard & Poor's 500 Index A commonly recognized, market capitalization weighted index of 500 widely held equity securities, designed to measure broad U.S. equity performance. Covers 500 industrial, utility, transportation and financial companies of the U.S. markets (mostly NYSE issues). Individuals cannot invest directly in any index. Barclays Capital Aggregate Bond Index Composed of all bonds from the Barclays Government/Corporate Bond Index, Mortgage- Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization. Individuals cannot invest directly in any index. London Interbank Offered Rate (LIBOR) Total return on cash assuming that funds are investment at the 1-month London Interbank offer rate. Alternative Investment Funds Risk Disclosure Interests of Alternative Investment Funds (the Funds ) are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of the Funds, and which Clients are urged to read carefully before subscribing and retain. This communication is confidential, is intended solely for the information of the person to whom it has been delivered, and should not be reproduced or otherwise distributed, in whole or in part, to third parties. This is not an offer to sell any interests of any Fund, and is not a solicitation of an offer to purchase them. An investment in a Fund is speculative and involves significant risks. The Funds are not mutual funds and are not subject to the same regulatory requirements as mutual funds. The Funds' performance may be volatile, and investors may lose all or a substantial amount of their investment in a Fund. The Funds may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Interests of the Funds typically will be illiquid and subject to restrictions on transfer. The Funds may not be required to provide periodic pricing or valuation information to investors. Fund investment programs generally involve complex tax strategies and there may be delays in distributing tax information to investors. The Funds are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits. The Funds may fluctuate in value. An investment in the Funds is long-term, there is generally no secondary market for the interests of the Fund, and none is expected to develop. Interests in the Funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period of time before making an investment in a Fund. Investors should consider a Fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, there are risks specifically associated with investing in hedge funds, which may include those associated with investing in short sales, options, small-cap stocks, junk bonds, derivatives, distressed securities, non-u.s. securities and illiquid investments. This document is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS Financial Services Inc. has no obligation to update such opinion or information. Options are risky and are not suitable for everyone. Please read the Options Clearing Corporation Publication titled "Characteristics and Risks of Standardized Options Trading". This Publication can be obtained from a Financial Advisor, or can be accessed under the Publications Section of the Option Clearing Corporation's website at optionsclearing.com. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 14

48 UBS Alternative Investments 22 February 2011 Hedge Fund Education Series Part 4: Important Hedge Fund Strategies Reports in this series Highlights Page Part 1: What are Hedge Funds? Part 2: Inside the Black Box Part 3: Asset Characteristics of Hedge Funds Part 4: Important Hedge Fund Strategies Equity Hedge 3 Equity Market Neutral 3 Dedicated Short Bias 4 Long/Short Equity 4 Emerging Markets 5 Event Driven 5 Credit Arbitrage 6 Distressed / Restructuring 6 M&A Arbitrage 7 Capital Structure Arbitrage 7 Macro Strategies 7 Global Macro 8 Commodity Arbitrage 8 Relative Value 8 Convertible Arbitrage 9 Fixed Income arbitrage 9 Statistical Arbitrage 10 Part 5: Implementing a Hedge Fund Portfolio UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. Hedge fund investment strategies tend to be quite different from the strategies followed by traditional money managers. Moreover, in principle every hedge fund follows its own proprietary strategy. This means that hedge funds are a very heterogeneous group. There are, however, a number of ideal types that can be distinguished, comprising broad categories. Figure 1 depicts the strategies as categorized by Hedge Fund Research (HFR). Having outlined the schematic, such neat classifications by strategy and style type (unlike in traditional investing) are both imprecise and, at times, not entire accurate as most managers have a fairly broad mandate. In the real world, strategy and style crossovers are commonplace. Any number of variations on the classification, or even other strategies, can be implemented by hedge funds. We then describe in some measure of detail the more important arbitrage strategies within the four broad groups of Equity Hedge, Event Driven, Macro and Relative Value. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. 1

49 UBS Alternative Investments 22 February 2011 Fig. 1: A heterogeneous industry with many sub-strategies Single-Manager Hedge Funds Multi-Manager Funds Equity Hedge Event-Driven Macro Relative Value Fund of Funds Equity Market Neutral Activist Active Trading Fixed Income Asset Backed Conservative Fundamental Growth Fundamental Value Quantitative Directional Sector: Energy / Basic Materials Technology / Healthcare Credit Arbitrage Distressed / Restructuring Merger Arbitrage Private Issue / Regulation D Special Situations Multi-Strategy Commodity: Agriculture Energy Metals Multi Currency: Discretionary Systematic Discretionary Thematic Systematic Diversified Fixed Income Convertible Arbitrage Fixed Income Corporate Fixed Income Sovereign Volatility Yield Alternatives: Energy Infrastructure Real Estate Diversified Market Defensive Strategic Short Bias Multi-Strategy Multi-Strategy Multi-Strategy Source: HFR Industry Reports, HFR, Inc., 1 Fig. 2: Industry composition by broad strategy types As of Q Relative Value 19.6% by # of hedge funds Relative Value 24.4% by Assets Equity Hedge 29.8% Equity Hedg 45.7% Macro 21.7% Equity Hedge 45.7% Macro 19.9% Event-Driven 13.1% Event-Driven 25.9% Source: HFR Industry Reports, HFR, Inc., 2

50 UBS Alternative Investments 22 February 2011 Equity Hedge The main objective of equity hedged funds is to seek long-term capital appreciation while maintaining very low net exposure to the overall stock market, individual industry groups, and other proxies of systematic risk, such as measures of value, growth, book leverage, or size. Often, their trading algorithms take into account behavioral biases of investors as well as constraints and competing incentives of institutional money managers. These biases and constraints create opportunities for profitable, risk-controlled equity trading. These managers use their expertise in accounting, valuation, behavioral economics, and empirical finance to identify opportunities and create stock selection models that rank the relative attractiveness of each stock in their investment universe. These rankings are often combined with estimates of risk and trading costs to construct diversified, risk-controlled long/short portfolios. Funds that practice long/short strategies in stock markets account for the largest share of the hedge fund universe. This is not surprising for the equity markets themselves are deep, liquid and large, representing around $50 trillion in assets. Equity Market Neutral This investment strategy is designed to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to be either beta 2 or currency neutral, or both. Well-designed portfolios typically control for industry, sector, market capitalization, and other systematic risk exposures. Leverage is often applied to enhance returns. The main objective of the market-neutral style of investing is to minimize market and sector risk by buying stocks, which are expected to outperform the market, and selling stocks short, which are expected to underperform the market. For example, hedge fund managers may wish to long biotechnology stocks (or any other sector specific) that are expected to outperform and short the biotechnology stocks that are expected to underperform. Therefore, what the overall biotechnology market actually does will matter little as the gain/loss is offset by both legs of the trade hence the low directional exposure or beta. This style thus seeks to achieve positive investment returns in falling markets as well as in rising markets. Fig. 3: Industry composition: equity hedge strategies As of Q Quantitative Directional 4.5% Multi-Strategy 3.9% Short Bias 1.3% by # of hedge funds Technology/ Healthcare 6.6% Energy/Basic Materials 5.5% Equity Market Neutral 11.5% Short Bias 0.3% Quantitative Directional 2.5% Multi-Strategy 1.0% Technology/ Healthcare 7.2% by Assets Energy/Basic Materials 6.5% Equity Market Neutral 5.3% Fundamental Growth 14.3% Fundamental Growth 24.1% Fundamental Value 62.9% Fundamental Value 42.6% Source: HFR Industry Reports, HFR, Inc., 3

51 UBS Alternative Investments 22 February 2011 Theoretically, when long and short positions are equally weighted and securities are paired for each sector, then the market-neutral style should render the portfolio insensitive to market risk. Market neutral strategies suffer less from cyclical patterns than the majority of other hedge fund strategies. Empirical evidence suggests that this strategy is a very powerful risk management tool in periods of market dislocation, e.g., August-September 1998, September 2001 or the 2008 financial crisis. Equity market neutral strategies have a general tendency to be positively correlated with high equity market volatility, and negatively correlated with spikes in equity volatility. In practice, there are always some uncovered risks, mainly stock selection risk, trade execution risk and market risk of unhedged positions. In addition, hedge positions may not completely eliminate market or sector risk. Therefore, active risk management is required to adjust positions regularly and keep a portfolio in line with acceptable market exposure. Hedge funds tend to rely on sophisticated risk management discipline. This includes relying on risk measurement to dictate position size; building diversified portfolio (often individual positions on average); moderate leverage; extensive use of option hedging strategies (both on individual positions and for systemic risk); and rigorous and disciplined stop-loss trading techniques. Dedicated Short Bias Dedicated short sellers were once a robust category of hedge funds before long bull markets rendered the strategy difficult to implement. A new category, Dedicated Short Biased, has emerged. The strategy is to maintain net short as opposed to pure short exposure. Short biased managers take short positions in mostly equities and derivatives. The short bias of a manager's portfolio must be constantly greater than zero to be classified in this category. Long/Short Equity This directional strategy involves equity-oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. Their focus may be regional, such as to be net long or net short U.S. or European equity, or it may be sector-specific, such as long and short technology or healthcare stocks. They tend to build and hold portfolios that are substantially more concentrated than those of traditional stock funds. The better hedge fund managers invest in long positions only where they have high conviction. To these longs, such managers add short positions in which they have high confidence. All positions, therefore, require high conviction based on a perceived information edge. Further, hedge funds need not be fully invested long unlike most traditional funds. This allows manager conviction, rather than an institutional mandate, to drive long and short exposure. Because they can vary exposure, hedge fund managers can press their bets when they are idea-rich and reduce exposure when they are not. They can be net short if their short-side ideas appear more promising. This category has slowly been morphing into two subclasses- High Directional Long/Short Equity where managers can be greater than 10-15% net long or net short and Low Directional Long/Short Equity where managers cannot be greater than 10-15% net long or net short. Low Directional managers may sometimes be included in the Equity Market Neutral category too. This is a strategy mainly based on fundamental research. This strategy combines bottomup fundamental research with secular trend evaluation to create the optimal portfolio of long and short positions. The process often utilizes small, medium and large capitalization companies to maintain maximum flexibility. 4

52 UBS Alternative Investments 22 February 2011 Emerging Markets This strategy involves equity investing in emerging markets around the world. Because many emerging markets do not allow short selling, nor offer viable futures or other derivative products with which to hedge, emerging market investing often employs a long only strategy. Due to different international trading patterns of individual countries, economic growth rates, monetary and fiscal policy, securities from different countries have different risk/return characteristics and imperfect correlation. International diversification can improve a portfolio s risk-return characteristics. But to invest in emerging markets has never been easy. Investors need to pay special attention to country risks, including political uncertainty, imperfect fundamental data and research information, non-standard and limited disclosure requirements, possible enforcement difficulties and limited remedies in the event of default etc. In addition to business uncertainties, such investments may be affected by political, social and economic uncertainty affecting the country or region. Many emerging financial markets are not as developed or as efficient as those in the U.S., and as a result, liquidity may be reduced and price volatility may be higher. Also the legal and regulatory environment may also be different, particularly regarding bankruptcy, corporate reorganization and financial accounting standards Regardless of the short-term higher returns or loss probability, many investors have reached an agreement that international diversification does increase a portfolio s return to risk ratio. This is evidenced in greater portfolio flows to emerging market (hedge) funds. Event Driven shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments..." More simply stated, this strategy has as catalyst, an event that either has altered or will alter the status quo of the company or companies in question. Through research, hedge fund managers determine if the marketplace is appropriately discounting the effect of that event on company valuations. If not, they have an opportunity to profit from that event-driven discrepancy. Event Driven strategies concentrate on the profit potential created by major corporate events, such as mergers, acquisitions, restructurings, bankruptcies, liquidations, etc. Unlike relative value strategies, which emphasize the theoretically-founded or quantitativelyestablished relationship among different but related assets, event-driven strategies are highly issuer and transaction-specific. They rely more on fundamental research and judgment than on mathematical precision. Hedge funds take positions that are expected to be profitable if a particular event comes to pass, while a variety of techniques are used to mitigate the risk that the event does not happen. The uncertainty associated with an event is not quantifiable in the same sense as a deviation between a theoretical and an actual price level. This creates an added dimension of risk. Event Driven strategies are dependent on market conditions conducive to major corporate events. For example, the probability of a merger being consummated is generally higher during a bull market or when primary debt issuance is very active. A basic distinction among Event Driven strategies is whether a position will be established prior to or only after the announcement of a proposed transaction. Preannouncement Event Driven investing involves not only the risk of eventual nonconsummation but also the risk that the anticipated event will never be announced in the first place. The Event Driven category of hedge funds constitutes the second largest strategy sector. Hedge Fund Research (HFR) defines Event Driven strategies as those that "maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, 5

53 UBS Alternative Investments 22 February 2011 Fig. 4: Industry composition: event driven strategies As of Q by # of hedge funds Activist 5.8% Credit Arbitrage 3.4% by Assets Activist 9.4% Credit Arbitrage 0.9% Special Situations 37.4% Distressed/Restru cturing 32.4% Distressed/Restr ucturing 24.6% Private Issue/ Regulation D 1.4% Multi-Strategy 10.0% Merger Arbitrage 9.6% Special Situations 56.9% Private Issue/ Regulation D 1.1% Merger Arbitrage 3.3% Multi-Strategy 3.8% Source: HFR Industry Reports, HFR, Inc., Credit Arbitrage A typical investment is to be long one debt instrument and short another to take advantage of temporary mispricing caused by corporate credit events. Distressed/Restructuring Distressed Securities are "below investment grade" securities and obligations of issuers in weak financial condition, experiencing poor operating results, having substantial capital needs or negative net worth. They may be the securities of companies facing special competitive challenges or product obsolescence problems. They may be involved in bankruptcy or other reorganization and liquidation proceedings. These securities are likely to be particularly risky investments although they also may offer the potential for correspondingly high returns. Among the risks inherent in investments in troubled entities is the fact that it is frequently difficult to obtain information as to the true condition of their issuers. The level of analytical sophistication, both financial and legal, necessary for successful investment in companies experiencing significant business and financial difficulties is unusually high. Hedge funds attempt to correctly evaluate the value of these assets and take "long" or "short" positions in the debt and/or equity of companies in financial distress and bankruptcy. The securities of companies in need of legal action or restructuring to reemerge from financial distress typically trade at substantial discounts to par value and thereby attract investments when managers perceive a turn-around will materialize. Managers may also take arbitrage positions within a company's capital structure, typically by purchasing a senior debt tier and short -selling common stock, in the hopes of realizing returns from shifts in the spread between the two tiers. In the volatile business climate, with a high number of defaulted bonds and Chapter 11 bankruptcy filings, the market for distressed companies' debt and equity securities continues to capture the interest and imagination of the investment community. The profitmaking potential of securities selling at discount prices makes distressed securities very attractive to educated and aggressively inclined investors. When a company is facing bankruptcy, even if it is because of temporary liquidity problem instead of long term insolvency, investors demand a large credit premium. Distressed security returns are a combination of the risk premium from holding low-grade securities and the liquidity premium from holding less liquid securities. Distressed securities are usually considered risky because there is a distinct possibility that the company might not recover. If that happens, the hedge fund may lose part or even all of invested capital. 6

54 UBS Alternative Investments 22 February 2011 M&A Arbitrage Capital Structure Arbitrage Risk arbitrageurs engaged in M&A Arbitrage typically long the stock of the company being acquired. They also often short the stocks of the acquiring company in stock-swap deals. The principal risk in such events is deal risk - should the M&A deal fail to close. The stock of the company being acquired will in general trade at a discount to the offer price, since all acquisitions take time and there always is risk that the acquisition will not be completed. M&A arbitrage funds make investment profits when they successfully anticipate the outcome of an announced M&A and capture the spread between the current market price and the price at which the stock trades after the M&A is completed. When a M&A transaction is pending, uncertainty about the outcome creates a pricing disparity between the price of the acquiring company s stock and the price of the target company s stock. If the deal is completed in the way the manager anticipates, profits will be made from the long position. M&A arbitrage hedge fund managers often do not attempt to anticipate possible M&As. Instead, they analyze already announced M&A to identify favorable risk/return characteristics. This involves buying long and selling short different classes of securities of the same issuer in anticipation of profiting from the correction of a relative mispricing among them. One particular form of Capital Structure Arbitrage involves buying long a fixed-income security of an issuer and entering into a credit default swap, which calls for payment to the hedge fund of the principal amount of the fixedincome security against that security s delivery in the event that the issuer suffers a credit event (essentially, an event tantamount to default on its debt). Another form of capital-structure arbitrage involves buying long an issuer s equity and selling short that issuer s debt, with the assumption that the equity is underpriced relative to the debt. Macro Strategies Macro hedge funds, according to HFR's definition, trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets..." These managers primarily trade in the most liquid markets in the world, such as currencies and government bonds, typically betting on macroeconomic events such as changes in interest rate policies or currency devaluations. They rely mostly on an assessment of economic fundamentals. This strategy has the smallest share by assets. Fig. 5: Industry composition: macro strategies As of Q by # of hedge funds Systematic Diversified 33.5% Active Trading 4.9% Commodity 14.8% Currency - Discretionary 4.1% Currency - Systematic 6.8% by Assets Systematic Diversified 34.7% Active Trading 3.5% Commodity 5.5% Currency - Discretionary 2.2% Currency - Systematic 5.2% Multi-Strategy 12.8% Discretionary Thematic 23.0% Multi-Strategy 10.3% Discretionary Thematic 38.7% Source: HFR Industry Reports, HFR, Inc., 7

55 UBS Alternative Investments 22 February 2011 Global Macro Relative Value These managers carry long and short positions in many of the world's major capital or derivative markets. Their positions reflect views on overall market direction as influenced by major economic trends and events. The portfolios of these funds can include stocks, bonds, currencies and commodities in the form of cash or derivatives instruments. Most Global Macro funds are large and invest globally in both developed and emerging markets. They aim to generate high total returns by having the flexibility to invest in any asset class, in any geographical area, using any available instrument. They hold positions that reflect not only views on the fortunes of individual companies and/or sectors but also positions on broader world economic trends at the country level. Their positions need not be concentrated and will typically cover a wide range of equity markets, interest rate, currencies and commodities. Global Macro funds trading may be based on fundamental views or technical trading systems, or a combination of both. Fundamental analysts believe that changes in market prices are due to changes in supply and demand caused by changing economic conditions and that the most appropriate approach to investment decision making is to focus on economic factors. Technical traders generally believe that market prices are the key aggregator of information necessary to make investment decisions. Global Macro investing has traditionally been seen as dominated by a small number of huge players. It also exhibits a low correlation with equity markets suggesting an effective role as a diversifier for equity portfolios. Commodity Arbitrage Within this strategy, a typical investment is to be long one commodity and short another commodity when their historical, mathematical, or fundamental pricing relationship is temporarily distorted. The hedge fund manager identifies the distorted relationship and buys the cheap commodity and sells short the expensive one. By being long and short at the same time, the manager removes the directional risk of an unfavorable price move. According to HFR, in relative value strategies "the investment thesis is predicated on realization of a spread between related instruments.... Relative value strategies seek to profit from the relative mispricing of related assets- e.g., convertible bonds and the common stock underlying the conversion option; options and futures and their underlying reference assets; debt instruments of the same issuer or of different issuers with different maturities or yields; or the common stock of different issuers in the same sector. These strategies may be highly quantitative and based on theoretical or historical pricing relationships. Because they focus on capturing value from the relative mispricing of related assets, relative value strategies can generate returns that are independent of overall movements in debt or equity prices. Nonetheless, many of these strategies in fact are constructed with a long or short equity or debt bias. Because the mispricings that these strategies exploit tend to be small in absolute terms, relative value funds frequently use leverage, 3 at times substantial amounts thereof, in an attempt to increase returns. The use of leverage creates risks of credit squeezes and the adverse effects of discretionary margin increases by dealers and counterparties to which many other strategies are not subject. Few relative value strategies involve pure arbitrage, in which a profit will inevitably be recognized if the position can be held until maturity. 4 Moreover, it is typical of relative value strategies not to hedge all the risks of each strategy, due to the associated costs and the fact that certain risks cannot be effectively hedged. Relative value strategies are all (even in the case of pure arbitrage) subject to the fundamental risk that aberrational market prices, even if correctly identified, will not revert to fair value during the period over which the hedge fund is able to maintain its positions. Holding periods depend on the investment type and the duration of the underlying event. For example, risk arbitrage positions may range from one month to eight months and probably average four or five months. Event-driven equity trades too have a similar duration (with exceptions of course). Value-based equity trades 8

56 UBS Alternative Investments 22 February 2011 Fig. 6: Industry composition: relative value strategies As of Q by # of hedge funds Yield Alternatives by Assets Yield 6.8% Volatility 1.9% Volatility 10.3% Fixed Income - Asset Backed 15.6% Fixed Income - Convertible Arbitrage 11.3% Alternatives 1.8% Fixed Income - Asset Backed 6.7% Fixed Income - Convertible Arbitrage 8.7% Fixed Income - Corporate 16.2% Multi-Strategy 32.4% Fixed Income - Sovereign 4.9% Fixed Income - Corporate 18.8% Multi-Strategy 61.8% Fixed Income - Sovereign 2.7% Source: HFR Industry Reports, HFR, Inc., can have durations of up to two years and average over a year. Distressed security trades average two to eight months, sometimes even longer. Convertible Arbitrage Convertible bonds are fixed income hybrid securities that lie between straight bonds and stocks. They are typically listed securities issued by companies and traded on secondary markets. They give their holder the right, but not the obligation, to convert into a fixed number of shares of common stock. These shares are generally the stock of the issuer, but they could very well be of another company as well. A typical investment is to long the convertible bond and short the common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of stock, while protecting the principal from market moves. Current income is generated by combining the yield of the convertible security with the interest income on the proceeds from the short positions, less any dividends on the shares sold short. Most managers employ some degree of leverage, ranging from zero to 6x. The equity hedge ratio may range from 30 to 100 percent. Convertible arbitrage hedge funds focus on the mispricing of convertible bonds. Their rationale is that: Since convertibles are hybrid in nature, they do not attract pure bond and pure stock investors, giving rise to frequent price discrepancies. Convertible securities often contain several call, put, or exercise-date options that are often neglected by the market. The credit risk and interest rate risk of the convertible position is also hedged using appropriate instruments. Fixed Income Arbitrage Fixed income arbitrage hedge funds seek to profit from price anomalies between related securities and/or bet on the evolution of interest rates spread. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate swap arbitrage, U.S. and non U.S. government bond arbitrage, forward yield curve arbitrage and mortgage-backed securities arbitrage. The mortgage-backed market is primarily U.S. based, over-the-counter and particularly complex. It involves the purchase of the mortgage-backed securities and the short sale of other fixed income securities such as government bonds of the same term. A variant Basis Trading involves the purchase of a government bond and the sale of a futures contract on that bond. The downside of this strategy is limited to the difference between the price paid for the bond and 9

57 UBS Alternative Investments 22 February 2011 the proceeds from the sale of the futures contract. Traders look for price movements in both instruments over the holding period to determine if an arbitrage opportunity arises to realize a profit before final delivery of the bond in satisfaction of the futures contract. Statistical Arbitrage One form of statistical arbitrage is buying long a security (or basket of securities) and selling short a related security, option, or futures contract (or basket of securities, options or futures) when the relative prices of such securities, options or futures deviate from their historical relationship in anticipation of profiting from a reversion in the prices of such securities, options, or futures to their historical relationship. End Notes 1 For a detailed description: frx_strats& Beta is a measure of the volatility of the hedge fund s return performance relative to a benchmark financial instrument usually a broad index that serves as a proxy for the market. Typically a value of greater than 1 implies that the fund is more volatile than the benchmark and a value less than 1 implies less volatility relative to the benchmark. 3 While leverage presents opportunities for increasing the total return on investments, it has the effect of potentially increasing losses as well. Accordingly, the impact of any event which adversely affects the value of an investment could be magnified to the extent leverage is utilized and may result in a substantial loss. 4 An example is the mispricing between a stock index future and the underlying stock index, each of which necessarily will have the same value at the expiration of the future. 10

58 UBS Alternative Investments 23 February 2011 Hedge Fund Education Series Part 5: Implementing a Hedge Fund Portfolio Reports in this series Highlights Page Part 1: What are Hedge Funds? Part 2: Inside the Black Box Part 3: Asset Characteristics of Hedge Funds Part 4: Important Hedge Fund Strategies Part 5: Implementing a Hedge Fund Portfolio Manager Selection 1 Evaluating Managers 2 Due diligence 2 Investment Due Diligence 2 Operational Due Diligence 3 Monitoring Managers 3 Portfolio Construction 4 Implementation Considerations 5 Fund of Hedge Funds 5 Conclusion 6 As discussed in parts 3 and 4 of this series, selection of a hedge fund (HF) strategy, or strategies, is highly relevant in determining how a HF portfolio will fare under various financial market environments. Equally important, one can easily argue, is the task of implementing the selected strategy mix by choosing among HF managers in each of the selected strategies and skillfully combining them into robust portfolios. This installment sketches a framework for due diligence for selecting from among competing HFs and touches on aspects of portfolio construction. While financial professionals have specific regulatory diligence requirements, the issues discussed in this paper will also be useful to anyone considering an investment in HFs. Manager Selection UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. Due to the typical asymmetric risk/return characteristics of HF, investing in them warrants deeper analysis than investing in long-only managers. The skill of shorting securities is often under-appreciated by investors. Identifying HF managers who consistently, and over cycles, perform in the top 10% or top 25%, on a riskadjusted scale, is not easy and even once such managers are identified, they are often capacity constrained so getting access to them is not easy. Consequently, with the HF investor base and the industry serving them steadily growing, as described in the Part 1 of this series, manager skill is often quickly recognized and capacity snapped up. Managers of this caliber take in capital for only a very brief period and then hard close to new capital from all sources including existing investors. Alternatively, they can be "soft closed", accepting no new investors. Hence, there is considerable pressure to allocate capital to these managers very quickly or risk missing the opportunity. On the other hand, when capital flows are less discerning, many managers accept too much money, which can reduce or destroy their competitive 1

59 UBS Alternative Investments 23 February 2011 advantage something that astute investors need to avoid. Evaluating Managers In order to justify the higher fees charged by HFs, their returns should comprise more than simple market exposure, i.e. beta-based returns. They should rather (also) include a meaningful alpha return component. The latter derives from manager skill that is unrelated to market exposure. Some strategies, particularly those in credit and special situations investing, are more complex than others. Moreover, supply, demand and market technicals can impact them disproportionately. These strategies require managers with deep knowledge, expertise, and the right investment vehicle to extract excess returns. Other strategies such as those for quantitative arbitrage or high frequency trading have higher barriers to entry given complex and sophisticated trading approaches and considerable investments needed in computing infrastructure. These products require managers with proprietary and advanced tools coupled with experienced staff to analyze arbitrage opportunities. Managers differ substantially in their execution and implementation abilities. They also differ with regard to investment diversification, portfolio hedging, security hedging, the use of derivatives, the degree of leverage and the amount of short sales they undertake. It is therefore imperative that investors look beyond the risk and return profiles of fund strategies and more fully evaluate a potential manager s investment and risk management processes. While much of this evaluation is comparable to the process that would be used for a traditional active manager, there are some significant differences. Evaluating HF managers can be more difficult than evaluating traditional fund managers for a number of reasons. These include the lack of transparency in investment and risk management processes, limited knowledge of underlying portfolio positions especially concentration and short positions, the lack of standardized disclosure requirements and the complexity of strategies. More so than with traditional active managers, there are special risks associated with hedge funds that are particularly important to assess both before managers are hired and monitored on a continuing basis thereafter: Process Risk. This includes both investment and risk management processes. Both are critical to a manager s performance. The consequences of a breakdown or change in either one are potentially more severe than for managers of traditional long only stock or bond portfolios. Personnel Risk. The majority of HFs are relatively small, and turnover of key personnel may be more disruptive than for traditional managers. It is therefore common to insist on a "key man" clause that enables client fund redemptions in the event of such a departure of key persons from the hedge fund. Asset Growth Risk. Although there are many excellent large HFs, depending on the particular strategy and degree of leverage, HFs may experience downward pressure on expected returns if assets grow too large. Indeed, greater size may make a HF less nimble in its ability to effectively take advantage of market conditions, thereby shrinking the available set of arbitrage opportunities. It is for these reasons that in-depth due diligence research into investment and operational capabilities can often help identify HF managers who can generate skill-based returns consistently. Proper due diligence helps determine whether processes are performancedriven around specific, forward-looking objectives for return, risk and correlation. It also helps ascertain manager investment discipline, objectivity and consistency in decision-making. Due Diligence Investment Due Diligence The investment due diligence process involves reviewing the manager/ key risk takers' professional "pedigree", including their credentials, reputation, performance evaluation versus peers and benchmarks as well as the duration of such track records. 2

60 UBS Alternative Investments 23 February 2011 Attributes of the top hedge managers include Operational Due Diligence (i) (ii) (iii) (iv) excelling in systematically and dynamically analyzing the underlying markets and identifying conditions that might provide asymmetric arbitrage opportunities; having superior security selection skills and trade expression capabilities including shorting of securities; deploying a disciplined risk management approach; and being nimble in allocating capital across opportunities. Therefore, getting access to managers who have market knowledge and experience across varying markets and cycles, advanced analytical tools, developed risk management processes, flexible investment vehicles, and an edge in exploiting fleeting opportunities is critical. The due diligence function involves assessing these attributes and several other aspects including: a) investment theses and the process of arriving at them; b) investment philosophy; c) complexity of the investment strategy; d) sizing the trade and portfolio construction; e) organizational stability; f) employee turnover and compensation schemes; g) assets under management; h) costs, fees and pricing structure; i) liquidity conditions and j) operational and control checks. Operational risk analysis is a key factor in avoiding fund failure and manager fraud. It is important to build review procedures to enhance the ability to protect oneself from such risks. Operational due diligence typically includes an analysis of fund documentation, contractual arrangements, valuation methodology and pricing basis (including analysis of mark-to-market versus mark-to-model practices) and the strength of key service providers and administrators. It inevitably reviews operations infrastructure, systems, processes and controls including middle- and back-office staff qualifications and capabilities. It also includes ongoing media and background check monitoring and considers the independence and quality of service providers. Lastly, it involves understanding the firm s approach to infrastructure issues including ways in which the firm is positioned to handle growth in assets/ or clients, personnel needs, client service functions and disaster recovery back-up arrangements. Monitoring Managers Once allocations are made, the ongoing monitoring process becomes an extension of the analytic and qualitative due diligence process completed prior to the investment decision. As with any active management strategy, the goal is to arrive at an early identification of factors that could cause future underperformance. Among these, the most critical include: a) style and strategy drift. The key concern is whether the HF is plying in strategies and investment processes for which it was hired or whether it is venturing into areas where either the arbitrage opportunities are likely to be less abundant or in which the HF's risk takers have not demonstrated prior expertise; b) size and investment liquidity. Investors need to monitor whether, with the growth of assets under management (AUM), the HF's position sizes are increasing and/or if it is venturing into, for example, large cap stocks or larger transactions when its core competency lay in analyzing small and medium size entities or transactions. On the flip side, a related concern is whether in 3

61 UBS Alternative Investments 23 February 2011 order to manage the larger AUM, the HF is moving into more illiquid or potentially more risky, transactions; c) lessened hands-on portfolio and risk management attention. This can sometimes happen due to satiation or development of other business interests; d) material change, if any, in the mix of investors and their proportions in the AUM of the HF. This is an important consideration as the action of other investors, such as a flood of redemptions, especially during times of market drawdowns can, and often does, negatively impact the returns of the non-redeeming investors; e) infrastructure for trading, risk management, client accounting and servicing is not in keeping up with the changed, hopefully increased, AUM. Recently, HF managers have come under pressure from regulators, clients, and potential investors to improve their disclosures about portfolio position, risk exposures and strategy evolution. There has been some progress in this direction, sometimes through third-party "aggregators". The latter receive proprietary securitylevel information files from the participating HFs. With a view to preserve the privacy of the security-level detailed positions held by each HF manager, yet to provide a meaningful level of disclosure to investors, they aggregate the information and provide portfolio level metrics on the holdings as well as several risk measures for the portfolio. These developments, while desirable, have made the monitoring of HFs more involved. Portfolio Construction Hedge funds come in different flavors regarding their mix of beta and alpha return components. While many claim to be absolute return providers, meaning that they would provide positive returns regardless of the broad market ups and downs, few genuinely are. True, that due to their ability to short securities and/or engage in trades to hedge out elements of risk which they determine do not provide an adequate expected return for the risk borne, they should be expected to be less correlated with the return patterns of traditional long-only investment portfolios. For example, by shorting an industry sector index they may reduce exposure to that industry sector, or by buying credit protection they may be able to reduce credit deterioration in the bonds that they may hold long. So, shorting can at least provide a partial hedge against declining markets. However, truly market neutral HFs that are alpha producers are few and far between. So, while their hedging activities generally tend to reduce hedge fund s correlation with long-only investments, thereby providing portfolio diversification, that is not always the case. HFs do retain some net long exposure and may have some elements of leverage too. In addition, they are not immune to the illiquidity risk of the broader market. Correlations across securities and markets tend to rise in such times of stress as they did in late 2007 and that may cause HFs to provide less diversification than expected. These are important issues to be borne in mind during portfolio construction and particularly so for investors relying on a "core and satellite" approach to determining asset allocation / portfolio mix. When considering a HF as a candidate for inclusion in an existing or proposed portfolio, in addition to the due diligence on it one also needs to estimate its correlation overlap and incremental expected risk/return impact on the portfolio. Clearly, the greater the number of HFs in the portfolio, the more the aggregate portfolio will mimic an index-like portfolio, thereby increasing the probability that the fund will underperform the benchmark index net of management fees. This is akin to the overdiversification concept for long-only securities. Providing alpha returns is the goal of all actively managed portfolios. But sourcing of such uncorrelated alpha is challenging, to say the least. In conclusion, therefore, the criteria for assessing the suitability of candidate HF strategies and manager combinations should include: Estimating projected alpha and alpha volatility for each strategy/hf 4

62 UBS Alternative Investments 23 February 2011 Estimating historical beta exposures for each strategy/hf Fund of Hedge Funds Incorporating uncertainty in alpha forecasts, alpha volatility estimates and beta estimates through confidence interval measures Keeping in mind downside risk characteristics of each strategy s/hf s alpha Correlations across different strategies /HFs alphas and betas Implement Considerations Portfolio diversification is a well understood concept, best popularized by the adage not to put all of one s eggs in the same basket, and formalized by the Markowitz portfolio diversification approach. Yet, there are still numerous examples of investors taking excessive risk by investing in only one or two hedge funds. True, the counter-argument that "nobody ever got very, very rich holding a diversified portfolio" also holds water. The crux, then, is to determine the risk bearing ability of the investor and invest accordingly. Typically, this evaluation is a function of the wealth level of the investor. The avenues to include HFs in a non-institutional portfolio include the following: a) self-managed, b) discretionary account, c) advisory account, d) separate accounts, e) investment via Fund of Hedge Funds (FoHFs). Each of these have their own advantages and disadvantages particularly as to the due diligence burden (borne or delegated), strategy and portfolio transparency, on-going monitoring and evolution, portfolio re-balancing, additions/ deletions and so on. Clearly, the ideal route among these would emerge from a cost-benefit analysis via-a-vis the amount of investment contemplated, the investor s risk bearing capacity and desire, holding period horizon and wealth level. Hence it is not uncommon for non-institutional investors to choose among these alternatives and often deploy a combination of these often through their professional advisors. FoHFs offerings comprise of portfolios of HFs with strategy or allocation concentration of focus. For example, a FoHF product may be a fund of long/short equity HFs diversified by the number of the constituent funds i,e. concentrated or diversified, or by their investment geographies i.e. domestic or global or emerging markets, or sectors e.g technology FoHFs. There are also multi-strategy FoHFs or fixed income or relative value FoHFs. In short, FoHFs can offer investors exposure to a wide range of alternative investment styles and strategies. This allows the investor to offload to investment professionals the tasks of due diligence, fund selection, record-keeping and monitoring managers in addition to providing access, and tactical asset allocation overlay all value-added services. FoHFs may also be able to negotiate more transparency and fund liquidity than might be available through direct hedge fund investments simply because of their aggregated size and allocations to a particular hedge fund. Smaller investment size FoHFs provide investors access to multiple hedge funds with a much smaller investment than the minimum required by individual hedge funds. Unless targeted for the retail investor, minimum initial investment requirements for some hedge funds running into millions of dollars. Therefore, building a diversified hedge fund portfolio typically entails a significant investment amount for the investor. Access to capacity constrained funds Many single-manager hedge funds are closed to new investors, due to capacity constraints. However, FoHFs run by managers with good relationships in the hedge fund industry are often able to invest in these funds. Due to the aggregate size of investment in each selected hedge fund, FoHFs typically may be viewed preferentially by hedge funds seeking to raise their AUM. However, in the downturn of 2008, contrary to expectations, FoHFs were in fact among the fastest to redeem money from the managers. Therefore, there is some wariness to accepting funds from the run-of-themill FoHF. Hence, selection of a FoHF through which to invest is of significant importance regarding gaining access to limited capacity. 5

63 UBS Alternative Investments 23 February 2011 More liquidity Hedge fund liquidity varies by the strategy and the underlying liquidity of the investment instruments as well as the investment theses and the time needed to realize them. Some may impose longer liquidity terms to prevent fast entry and redemptions that hurt all investors. While some FoHFs provide shorter liquidity terms, that may be due to their portfolios comprising of such shorter redemption period hedge funds. Alternately, they may be taking a redemption mismatch risk, the desirability of which may be questionable. Costs Certainly these advantages come at a price. Fees are charged by both the FoHF manager and the underlying hedge funds. In some cases, FoHF managers may be able to mitigate these fees by obtaining fee rebates from the underlying managers, taking advantage of the substantial allocations they can make to the manager. However, such fee rebates are increasingly uncommon because they are disclosable items; every institutional investor will require such discounts too under the so-called "most favored nation" status. So the cost of the added level of fees arising in a FoHF needs to be weighed against the access, benefits and services that FoHFs provide. Conclusion As market events are reflected differently in each strategy and in each HF, combining a portfolio of HFs with different but complementary investment styles and risk/ return attributes is desirable. However, a naive diversification across a large number of HFs and strategies may be suboptimal in that it may not be fully effective in reducing market and credit risk, or specific risk of a particular HF. Also, given finite resources, monitoring a large portfolio of HFs often increases portfolio risk in light of the increased demands on due diligence capabilities. Conceptually, the place to start is to separate skill based alpha components from systemic beta components; combining managers on the basis of non-correlated alphas is a target to shoot for in an effort to arrive at the desired level of diversification. This entails careful selection of exposure to strategies and HFs. Admittedly, this is easier said than done but perhaps therein lies the return to research and investment effort expended. In this piece we have outlined the general considerations needed to create such a portfolio. 6

64 UBS Alternative Investments 23 February 2011 Alternative Investment Funds Risk Disclosure Interests of Alternative Investment Funds (the Funds ) are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of the Funds, and which Clients are urged to read carefully before subscribing and retain. This communication is confidential, is intended solely for the information of the person to whom it has been delivered, and should not be reproduced or otherwise distributed, in whole or in part, to third parties. This is not an offer to sell any interests of any Fund, and is not a solicitation of an offer to purchase them. An investment in a Fund is speculative and involves significant risks. The Funds are not mutual funds and are not subject to the same regulatory requirements as mutual funds. The Funds' performance may be volatile, and investors may lose all or a substantial amount of their investment in a Fund. The Funds may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Interests of the Funds typically will be illiquid and subject to restrictions on transfer. The Funds may not be required to provide periodic pricing or valuation information to investors. Fund investment programs generally involve complex tax strategies and there may be delays in distributing tax information to investors. The Funds are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits. The Funds may fluctuate in value. An investment in the Funds is long-term, there is generally no secondary market for the interests of the Fund, and none is expected to develop. Interests in the Funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period of time before making an investment in a Fund. Investors should consider a Fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, there are risks specifically associated with investing in hedge funds, which may include those associated with investing in short sales, options, small-cap stocks, junk bonds, derivatives, distressed securities, non-u.s. securities and illiquid investments. This document is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS Financial Services Inc. has no obligation to update such opinion or information. Options are risky and are not suitable for everyone. Please read the Options Clearing Corporation Publication titled "Characteristics and Risks of Standardized Options Trading". This Publication can be obtained from a Financial Advisor, or can be accessed under the Publications Section of the Option Clearing Corporation's website at optionsclearing.com. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 7

65 UBS Alternative Investments 19 December 2011 Part 6: Alpha Characteristics of Hedge Funds Highlights Page Introduction 1 Separating Sources of Manager Value Creation 2 Changing Market Risk Exposure 2 Measuring the Value of Timing Decisions 3 Challenges in Measuring Changing Market 3 Exposures Measuring Changing Beta Kalman Filtering 5 Kalman Filter Results 7 Results of Our Analysis 9 Alpha Return by Strategy 9 Alpha Volatility by Strategy 10 Information Ratio by Strategy 11 Do HFs Create Alpha in Bear Markets 12 Do HFs Create Alpha in Bull Markets 13 Implications of Absence of Market Timing Alpha 14 Conclusion 14 Authored by: Sameer Jain, UBS Alternative Investments Andrew Yongvanich, UBS Alternative Investments Xinfeng Zhou, Phd, CFA * UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. Introduction Hedge Fund (HF) managers are expected to create excess investment returns (Alpha) through two primary skills based sources: Security selection: buying undervalued securities and selling overvalued securities. Market timing: entering markets in advance of, or when they are rising and exiting, or shorting them when they are declining. In this paper we employ a Kalman Filtering approach to measure the skills based component of HF returns. We separately quantify value generated through market timing and security selection decisions over various market regimes and detail the characteristics of HF Alpha. Key Takeaways HF managers have historically generated meaningful, excess, skill based returns (Alpha) through active management. These excess returns, whilst still very significant, have decayed over time as the industry has grown. The Alpha in HF returns has consistently come from security selection decisions. The Alpha in HF returns has been reduced by market timing decisions. The benefits of taking risks to generate active skill based returns outweigh their costs. In secular equity bear markets, HFs have significantly outperformed on both an absolute as well as on a risk adjusted basis. In secular equity bull markets, HFs have sacrificed some upside but have been less volatile and have outperformed on a risk adjusted basis. Quantification of time varying Alpha has important implications for manager selection, asset allocation and portfolio construction. * Non-UBS Contributor 1

66 UBS Alternative Investments 19 December 2011 Separating Sources of Manager Value Creation HF manager returns are seen to be a combination of passive exposure to general market factors (referred to as Beta) and active investing decisions resulting in market outperformance (referred to as Alpha). Alpha, in other words, is the skills based return component accruing from (i) an ability to time the markets i.e. to directionally lever and de-lever positions, thus magnifying or diminishing levels of exposure to markets and (ii) from security selection (to go either long or short). While most practitioners agree that securities selection has the potential to generate Alpha in investing, not much is known about the value generated from market timing decisions alone. Surprisingly, it is poorly understood how HFs produce meaningful Alpha over long term market cycles. Generally, when investors and analysts assess manager outperformance to the market or Alpha they combine market timing and security selection sources, rather than distinguish the unique contribution of each to a manager s risks and returns. Once one separates a manager s Alpha into market timing and security selection components, one can determine whether each component adds value on a stand-alone basis. In this article, we outline a theoretically sound framework for measuring changing exposures to underlying markets. By identifying and measuring such changing market exposures or dynamic Betas of HF managers, we are able to break down a HF strategy's returns and risks into three distinct components: Beta: the portion created by the passive average long-run market exposure. Market Timing Alpha: the portion created by proactive variations in market exposure around the passive average exposure over time. Security Selection Alpha: the portion remaining, due to security selection and stock picking skills both long and short. We outline here a Kalman Filtering approach (described in detail later) for measuring value generated through market timing and security selection decisions. Our analysis suggests that HF managers have historically generated Alpha across most strategies especially through security selection, but they have detracted value through their market timing decisions. This however does not necessarily indicate that all HF managers are bad market timers, for our study was done at an aggregate industry level by strategy type; when we tested selectively on proprietary data for a biased sample of manager returns, we did detect market timing Alpha, albeit on an inconsistent basis. Our analysis also suggests that during bear markets, in particular September 2000 September 2002 and November 2007 February 2009, HF managers have significantly outperformed the broad equity index by protecting downside risk. Changing Market Risk Exposure HFs pursue absolute return strategies in an attempt to generate attractive returns in a variety of market conditions. Accomplishing this goal requires significant flexibility including the ability to increase or decrease exposure very quickly, short sell markets and securities, invest in illiquid securities, shift strategies as well as rotate across sectors or asset types. Skillful managers are expected to anticipate favorable market movements by increasing exposures in advance of, or with, rising markets or decreasing exposures in advance of declining markets i.e. adjust their Betas in anticipation of broad market moves. These short to medium term shifts to preempt markets are essentially market timing decisions. The question for investors, therefore, is to understand to what extent such market timing decisions add value. If a HF manager is good at market timing, investors may feel comfortable allowing them to change exposures to different markets as they see fit. On the other hand, if a manager is a poor market timer, such tactical bets could add significant risk without a commensurate increase in returns. Active Management Why do market exposures of HF strategies change over time? In many cases, managers actively manage market exposures as an explicit way to create value. If a manager believes that a certain equity market is undervalued, then for a period of time, he will potentially increase exposure to those equities in that market as a means of creating value, or in other words generate market timing Alpha. In other cases, however, a change in market exposure is a by-product of a strategy to create value, say through security selection. In this case, changing exposures happens without regard to explicit market timing value-creation; the value-creating strategy is based on some other premise, often valuations based security selection. As an example, it may be the case that an equity longshort manager is changing her Beta over time simply as 2

67 UBS Alternative Investments 19 December 2011 a result of changes in the attractiveness of valuations in high Beta (small cap) versus low Beta (large cap) stocks. Measuring the Value of Timing Decisions In this paper we have dispensed with most of the mathematics that we used in building our models, except for a few equations that are integral to the explanation. Most readers may however, skim these equations without loss of comprehension, or direct their attention to the results of our analysis on page 9. In order to decompose the various aspects of HF Alpha, we first need a way to quantify the market timing component of returns. One conceptually simple approach is to examine a manager s exposure to the markets that he trades at every point in time. If on average the manager increases his exposure to markets when they go up, and decreases exposure to these markets when they go down, the manager will generate positive returns through market timing. Comparing the returns from a manager s average market exposures to the returns from the manager s time varying market exposures can therefore help determine value added from market timing. More formally, we can express a manager s returns as follows: Rt t m, trm, t t t mrm, t m, t m Rm, t t (1) where R t is the manager s excess return over cash at time t, t is the expected Alpha at time t, m,t is a vector of the manager s exposure to the market at time t, R m,t is the market s excess return over cash at time t, and t is the residual variation in the manager s return. The first equality term in the above equation is a fairly standard representation but things get more interesting when we examine the second equality term, which is in fact, a measure of Active Beta or market timing. m Estimating Active Beta: If we define as the manager s average Beta exposure, mt m is the manager s Active Beta exposure based on the manager s timing decisions. Equation (1) therefore states that a manager s return at each point in time consists of four components: 1. Expected Alpha based on security selection decisions, t 2. A return based on the manager s average exposure to the market, mrm, t 3. A return based on the manager s market R timing decisions,, mt m m t 4. A residual component with zero mean, corresponding to the risk generated from security selection decisions, t Computingmt m Rm, t, we generate a time series of the manager s market timing returns and estimate the expected return and standard deviation of market timing returns; i.e., the Alpha and Alpha volatility from market timing decisions. Challenges in Measuring Changing Market Exposures The challenge that investors face, and much of the literature on the subject ignores, is in measuring market exposures on a time varying basis. Standard factor models assume that market factor exposures are constant through time, as shown in the fairly popular equation (2). Rt t mrm, t t (2) As a result, returns from market timing are captured in the coefficient. If a manager has generated positive Alpha (), investors have no way of knowing how much of this comes from market timing versus security selection. However, this distinction is crucial to understanding how managers have generated returns, and to what types of risks (whether market timing or security selection) they have been exposed to. As an example, a long short equity manager who is poor at market timing may have substantial exposure to the equity market during a downturn. Investors with significant equity positions in their portfolios may want to avoid this manager, or at the very least, actively manage their equity exposure in a way that offsets the manager s market timing decisions. We tested multiple approaches to isolate the market timing component of manager returns and present our findings in Figure A and Figure B (page 7 and 8). 3

68 UBS Alternative Investments 19 December 2011 Approach 1: Ordinary Least Square Regression (OLS) In calculating the historical Beta, or historical market exposure, a popular approach is to undertake a regression analysis of the HF returns series against one or more explanatory factors. These explanatory factors are usually tradable market factors such as the S&P 500 index returns; the presumption being that market factors can be used to model HF returns and any return above the market return is the manager's excess return, Alpha. Whilst intuitively appealing, this leads, as it did in our case, to spurious results. This is because underlying factor sensitivities (i.e. relationships between market factors and HF returns) are never constant over the estimation period but vary over time. This method measures an average Beta effect over the estimation data set, but at any given time, the expected value of market Beta is quite different from the true value. In other words the method estimates past average factor exposures over a long period of time. It does not explain how exposures have evolved over time and thus has very modest explanatory power for arriving at a manager's true Beta at any given point in time. Approach 2: Rolling Regression An improvement over the OLS method is the rolling regression. This method consists of applying the OLS regression model to a rolling window of observations. In practice, when investors estimate Beta from monthly return series, a 36 to 60 month history is often used to achieve a good balance between bias and variance. In our study, we chose a window size of 36 months to yield better sensitivities to Beta changes. We did an OLS regression of a HF strategy's excess returns against market returns between time periods t 35 months and the current time period t which yielded estimations of t and t at time t. The size of the rolling window reflected the trade-off between capturing the Beta variation over time and reducing sampling error. However, we found that if the data set was too large, stale data in distant history caused the model to be less responsive to Beta changes and introduced bias in the estimation. Conversely, in those cases when the data size was small, noises in the short history caused the regression model to fit the noises in the data and introduced variance in the estimation; in statistics, this is called bias/variance tradeoff. A drawback in this widely used approach is that rolling regressions too are not suitable for time-varying sensitivity estimation. This is because the regression estimates an average sensitivity over each rolling window. We discovered that sensitivities computed from adjacent windows of time (i.e rolling periods) are highly correlated and if actual sensitivities vary over time, or follow a trend, they depart from their average. We were also aware that another fallacy in this approach was that the regression ascribed all data between t 35 months and t with the same weights instead of giving more recent data higher weights. We therefore modified our model by giving more importance to recent observations as described below. Approach 3: Time Weighted Regression This approach overcomes some of the limitations of the OLS and rolling methods described earlier by giving more importance to recent observations. In testing this, we used a decay rate to determine the speed at which the weight of an observation decreases with time. This popular procedure is known as weighted least squares (WLS) estimation. We used an exponentially weighted least-square regression to assign recent data higher weights: the data point at t i i had weight (0 < < 1), we choose = 35/37 and a half life of the exponential weighting ~12 months i.e. a data point from 12 months ago had half of the weight as the most recent data point. To compare with the earlier approaches we stuck to a 36 month window size. These Approaches Do Not Work Our results suggest that although rolling window regressions and time weighted regressions are popular choices for estimating average Beta, they are inadequate at capturing dynamic Beta variation and providing clues about a manager's ability to time markets. This was especially true where the time horizon was much smaller than the window size. For example, if a HF strategy's Beta was historically close to 0.5 and increased to 0.7 in a month, the Beta estimated using OLS with 36 months data, changed less than 0.2 ( 0.7 minus 0.5) since the most recent data point (0.7) was only one data point out of 36 data points in the regression. Further, if in a subsequent month, the Beta exposure decreased to 0.1 from 0.7, the regression yielded a Beta close to 0.5; since the previous data point with higher Beta (0.7) had far higher weight which reduced the information content in the newest data point that had a much lower Beta (0.1). Also, in practice, HF managers make market timing decisions on time scales far shorter than 36 months, rendering traditional regression approaches ineffective for capturing market timing decisions. Moreover, these 4

69 UBS Alternative Investments 19 December 2011 approaches did not provide any way to model the sensitivities of factor exposures in the returns time series. They measured past (weighted) average sensitivities. In addition, all sensitivity coefficients in the regression equation were identically affected by the weighting, regardless of their rate of change as the weights only depend on the position of the observation in the time series. A Better Approach to Measuring Changing Beta Kalman Filtering We propose that measuring a manager s market timing ability requires a new estimation framework, one that adapts to and dynamically reflects the manager s actual exposures. After extensively testing, we discarded regression based approaches and chose to estimate HFs dynamic Betas using a filtering procedure. This approach, borrowed from engineering, treats Betas as state variables that follow an autoregressive process. As is fairly well known in signal processing, when it comes to separating impurities from valuable information, a key feature of any high quality filter is to keep as much useful data as possible while eliminating less meaningful data. However, due to the difficulty in differentiating between the two, it is almost always impossible to obtain 100% pure information. The most acceptable compromise is to adopt an approach that establishes the minimum estimation error with respect to the true value. The Kalman Filter is an approach that has been shown not only to work well in practice, but proves to have smaller estimation error than most other techniques in a broad array of situations. We used the Kalman Filter to generate estimates of a time series of hidden true information using observable data that was accompanied by a lot of noise. By combining this filtering technique with statistical estimation methodology, we were able to obtain the hidden true information HF market risk exposure and time varying Beta - with a fair degree of precision. The basic structure of the Kalman Filter has two parts: (i) a measurement module, and (ii) a process module. While the measurement module connects the unobservable information (HF market risk exposure) to the observable data (monthly returns data of the HF index), the process module describes a model that allows the unobservable data to evolve through time. Once we started with a good estimate of market risk exposure with some degree of confidence in that estimate, we could predict a better estimate of future market risk exposure - through the process and measurement module by using only expectations and not the variance associated with the predicted values. After this, the next step was to compare the predicted value with the realized value and minimize the error to improve the predicted value iteratively for the next period. Technical Description Our filter can be expressed using an observation equation and measurement equation, as shown below: Observation Equation Rt t m, txt t (3) where ~ N0 R t, Process Equation t t 1 M t mt, mt, 1 where M is a 2 2 state transition matrix that models the dynamics of expected Alpha and market Beta over time, t is a vector of serially uncorrelated disturbance with mean zero and covariance matrix Q, t ~ N0, Q. Estimates for t are derived using the following equation: K ( R Rˆ ) (5) 1 tt tt1 t t tt where ˆ t t (4) is the estimate of the manager s time t ˆ t market exposures at time t, t 1is the estimate of the manager s time t market exposures at time t 1, R t is the manager s actual return at time t, Rˆ t t 1 is the manager s time t predicted return at time t 1, and K t is the Kalman Gain. Conceptually, the time t Beta estimate depends on the previous Beta estimate, the difference between the predicted and actual return, and the Kalman Gain. The Kalman Gain, in turn, is a function of the observation noise ( t ) and the process variation ( t ). If the observation noise is high relative to the process variation, the Beta estimates will be relatively stable. On the other hand, if the process variation dominates the observation noise, the Beta estimates will fluctuate substantially. 5

70 UBS Alternative Investments 19 December 2011 Kalman Filter Provided Superior Results We established that the Kalman Filter approach outperformed both time weighted and rolling regressions, for it optimally used all information about a manager s returns. Exponentially weighted regressions or rolling regressions, by contrast, made arbitrary judgments about how much importance to attach to each observation, and lead to less reliable estimates. However, one of the drawbacks in using Kalman Filtering, was that it required a significant amount of data. While an OLS regression may be reliably estimated with as few as 30 data points, Kalman Filtering requires an order of magnitude more data, depending on the number of factors. Fortunately, we were able to limit this drawback to some extent by adding more structure to our model. For example, we assumed that Alpha and Beta is not correlated i.e while both Alpha and Beta have their own variance the covariance between Alpha and Beta- i.e. the offdiagonal elements in the Q matrix are zero - and were able to reduce the amount of data required to properly estimate the Kalman model. Kalman Filter Results One of the practical advantages of the Kalman Filter was that due to the filtering property, information from the previous steps was accumulated in the variance of best estimate, and the variance of best estimate was reduced relative to the variance of better estimate. In essence this filter recursively minimizes estimation error without observing the hidden (market factor exposure) information. In Figures A and B, we provide empirical evidence of the minimum error property by filtering the HFRI Equity Hedge index's excess returns into US market excess returns for the S&P

71 UBS Alternative Investments 19 December 2011 Kalman Filter Results (continued) Figure A: HFRI Equity Hedge Beta Exposure HFRI Equity Hedge Market Beta Exposure Kalman Filter Ordinary Regression Weighted Regression Jan1993 Jan1995 Jan1997 Jan1999 Jan2001 Jan2003 Jan2005 Jan2007 Jan2009 Jan2011 While normal regressions show a relatively flatter and smoother pattern of Beta changes- as seen in the green and red lines-, the filtering technique produces much more dynamic picture as seen by the more volatile blue line - of change in market exposures. When we compared the mean square error, the statistical measure of how much the forecasted value differed from the realized value, the filtering technique turned out: (i) to have 27% lesser error than from normal regression and (ii) to have 18% lesser error than from the weighted regression technique. By making the error component as small as possible the Kalman filter was able to pick up changing Beta exposures faster which, as described earlier helped us determine Active Beta, and market timing Alpha. 7

72 UBS Alternative Investments 19 December 2011 Kalman Filter Results (continued) Figure B: HFRI Equity Hedge Annualized Alpha HFRI Equity Hedge Annualized Alpha Kalman Filter Ordinary Regression Weighted Regression Jan1993 Jan1995 Jan1997 Jan1999 Jan2001 Jan2003 Jan2005 Jan2007 Jan2009 Jan2011 Figure B plots expected Alpha over time. It suggests that, except for a brief time period in 2008, over nearly all other time periods HF managers have generated Alpha. The skills based component of returns generation has been of particular value to investors, as we will later demonstrate. Figure B also suggests a discernable trend in diminished Alpha over time, though. Our calculations suggest that after 2003 the average Alpha in the Equity Hedge strategy has been around 3% to 4 % while for the six years following 1993 the average Alpha was around 9%. Despite the decay, our analysis suggests that HFs have significant and persistent excess returns that are from security selection based, rather than market timing based. We do not know the reasons for Alpha decay. It is entirely possible, that as HFs have proliferated over the years, the underlying markets for their securities may have become more efficient. Also, growth in assets under management may have curtailed their ability to uncover arbitrage opportunities or have reduced their capacity for implementation. Another reason could be that the greater institutionalization of the industry, as well as risk from outflows/ investor redemptions, may have reduced their propensity for risk-taking. Another point, which bears with intuition is that, one would not expect long term expected Alpha to fluctuate as much as Beta (as compared with Figure A), and indeed our results bear that out. We further conducted this exercise for HFRI Event Driven, HFRI Macro, HFRI Market Neutral, HFRI Quantitative Directional and HFRI Short Bias indices and found results that were not too different. 8

73 UBS Alternative Investments 19 December 2011 Results of Our Analysis Figure 1 and 2: Alpha Return by Strategy Figure 1: Alpha Return by Strategy ( ) Security Selection M arket Timing 1.3 % HFRI Short Bias 0.4% Figure 2: Alpha Return by Strategy ( ) Security Selection M arket Timing -0.6% HFRI Short Bias -2.5% HFRI Quantitative Directional -0.8% 5.9% HFRI Quantitative Directional -0.2% 4.2% HFRI M arket Neutral -0.3% 6.7% HFRI M arket Neutral -0.5% 6.5% HFRI M acro 0.8% 5.3% HFRI Macro 1.4% 3.2% HFRI Event Driven -0.5% 7.0% HFRI Event Driven -0.9% 5.8% HFRI Equit y Hed ge -0.8% 6.7% HFRI Equity Hedge -0.9% 3.1% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% -4% -2% 0% 2% 4% 6% 8% Source: Hedge Fund Research, UBS Al Source: Hedge Fund Research, UBS Al We analyzed Alpha characteristics for three major HF strategy groupings equity hedge, event driven, macro as well as three sub-strategies in the Equity Hedge index. Those being, market neutral, quantitative directional, and short bias strategies. Figures 1 through 6 compare the level of Alpha return, Alpha volatility or risk, as well as the Information Ratio from security selection versus market timing for these six strategies. With the exception of global macro and short biased, all other strategies had negative market timing returns. We conclude that in aggregate, HF managers have not been able to produce positive Alpha return through market timing over the long run. This result is not particularly surprising as very few managers, both in the traditional active longonly space, or in mutual funds too, have been successful at persistently timing markets correctly over different market cycles. Global macro managers have produced Alpha return through market timing over both the long and short run. This is perhaps because macro managers are given a wider mandate enabling them to participate across all asset classes including equities, fixed income, interest rates, currencies and commodities. Macro strategies are primarily centered on directional Beta timing investments which may explain their ability to generate market timing Alpha returns. However, all HF manager strategies have generated significant excess return through security selection. While there has been some Alpha return decay through security selection in the past decade, most HF managers still produce meaningful Alpha return. Market Neutral is the largest Alpha return producer through security selection at approximately 6.5%, suggesting that HF managers have unique skills in going both long and selling short. Equity Hedge strategies have seen the most decline in Alpha return across time. This could be attributed to the fact that it is the most popular strategy by number of firms, funds and largest AUM which may have resulted in a drag from underperforming managers. The analysis suggests that over the past 20 years, HF managers destroy value through market timing, very similar to findings from active long-only managers. However, due to HFs ability to participate in a wider range of investment instruments and markets, ability to short, and hedge, HF managers have delivered Alpha return over the long run. 9

74 UBS Alternative Investments 19 December 2011 Results of Our Analysis (continued) Figure 3 and 4: Alpha Volatility by Strategy Figure 3: Alpha Volatility by Strategy ( ) Figure 4: Alpha Volatility by Strategy ( ) HFRI Short Bias 5.4% 11.1% HFRI Short Bias 1.7% 4.5% HFRI Quantitative Directional 3.1% 6.6% HFRI Quantitative Directional 2.3% 4.5% HFRI Market Neutral 2.4% 4.1% HFRI Market Neutral 2.3% 4.1% HFRI Macro 3.1% 5.4% HFRI Macro 2.3% 4.2% HFRI Event Driven 2.1% 3.9% HFRI Event Driven 1.8% 3.4% HFRI Equity Hedge 1.9% 5.5% Security Selection M arket Timing HFRI Equity Hedge 1.7% Security Selection Market Timing 4.1% 0% 2% 4% 6% 8% 10% 12% Source: Hedge Fund Research, UBS Al 0% 1% 2% 3% 4% 5% Source: Hedge Fund Research, UBS Al Security selection, across all strategies, contributed more volatility to the funds when compared to market timing. Alpha volatility from market timing has ranged approximately between 2-4% while security selection has had a higher Alpha volatility between 4-7%. Even though both Alpha volatility components added additional risk to overall returns, returns derived from taking security selection risks outweigh the negatives as explained by an increase in the Information Ratios. It appears, as seen in Figure 3 and Figure 4, that almost all HF strategies have reduced their risk profiles since This may explain why most HF strategies have generated lower returns. Due to the recent market environment uncertainty and posture favored towards capital preservation, HFs appear to be taking less risk resulting in lower returns. Historically, quantitative directional strategies have produced the most Alpha volatility while event driven strategies have added the least. More recently, risk appears to be more evenly distributed. Because of this, we next examine the Information Ratio to determine Alpha per unit of risk taken. Ostensibly, if an investor is strategy agnostic, the strategy with the highest Information Ratio, is the one that ought to be chosen. 10

75 UBS Alternative Investments 19 December 2011 Results of Our Analysis (continued) Figure 5 and 6: Information Ratio by Strategy Figure 5: Information Ratio ( ) 0.1 HFRI Short Bias 0.0 Only Security Selection Security Selection & M arket Timing Figure 6: Information Ratio ( ) Only Security Selection Security Selection & M arket Timing -0.6 HFRI Short Bias -0.6 HFRI Quantitative Directional HFRI Quantitative Directional HFRI Market Neutral HFRI M arket Neutral HFRI Macro HFRI Macro HFRI Event Driven HFRI Event Driven HFRI Equity Hedge HFRI Equity Hedge Source: Hedge Fund Research, UBS Al Source: Hedge Fund Research, UBS Al The Information Ratio here is a measure of Alpha return per unit of Alpha risk undertaken to generate that excess skill based return. It removes Beta or market risk and isolates just the active risk the risk that HF managers are paid to take. Similar to the Sharpe ratio, the higher the value, the more attractive the strategy is on a risk adjusted basis. Our analysis theorizes that the Information Ratio of security selection alone is higher than that of combined returns from security selection and market timing. In other words, market timing actually destroys efficiency, even after taking into account that it provided diversification against security selection. We submit that if HF managers remove the market timing component and increase the risk exposure of security selection decision, one can achieve higher expected Alpha. In this context, therefore, our analysis provides a clear guide on whether the time variations in market exposures should be hedged in case where value is being destroyed, our answer is unreservedly yes. Historically, as seen in Figure 5 and Figure 6, almost all strategies have produced a positive Information Ratio; this advances our thesis that HFs, in the long term through multiple market regimes, outperform traditional investing strategies. 11

76 UBS Alternative Investments 19 December 2011 Do Hedge Funds create Alpha in Bear Markets? Figure 7: Bear Market Returns (09/ ) Figure 8: Bear Market Returns (11/07-02/09) 4.0% Security Selection -2.8% Security Selection 0.1% M arket Timing -3.8% M arket Timing -12.4% Beta Return -21.5% Beta Return -8.4% HFRI EH (Total) -28.1% HFRI EH (Total) -30.0% S&P -52.0% S&P -35% -30% -25% -20% -15% -10% -5% 0% 5% 10% -60% -50% -40% -30% -20% -10% 0% Source: Hedge Fund Research, UBS Al Source: Hedge Fund Research, UBS Al Figure 9: Bear Market Risks (09/ ) Figure 10: Bear Market Risks (11/07-02/09) Security Selection 3.6% Security Selection 6.2% Market Timing 1.9% Market Timing 3.3% Beta Return 7.3% Beta Return 8.1% HFRI EH (Total) 7.6% HFRI EH (Total) 11.5% S&P 17.7% S&P 19.5% 0% 5% 10% 15% 20% 0% 5% 10% 15% 20% 25% Source: Hedge Fund Research, UBS Al Now that we have established that HFs, in aggregate, have demonstrated an ability to create Alpha, we explore their performance in falling markets. We select Equity Hedge strategies as an example due to their large sample size and commercial popularity. As shown in Figure 7 and Figure 8, we tested for two periods of falling returns, September 2000 September 2002 and November February During periods of falling markets, Equity Hedge protected up to 50% in 2008/2009 and almost 72% in 2000/2002 of downside risk; we posit that these are not insignificant numbers. When comparing the different return drivers, Beta exposure in swift falling markets is the largest detractor of returns. HFs, for they are by definition Source: Hedge Fund Research, UBS Al hedged to Beta (a long term average of 0.41 for Equity Hedge) protect investors. One would expect that HF managers who cut net exposure to the equity markets when they are falling would outperform the markets still further. We however do not see this happening, as seen in Figure 7 and Figure 8; market timing has not created Alpha. Rather the Alpha of around 4% comes from security selection decisions in 2000/2002. In 2008/2009 security selection decisions was not a positive contributor as correlations peaked, and individual securities moved inline with the markets irrespective of sector, industry or geography. Prices deeply diverged from fundamentals as markets 12

77 UBS Alternative Investments 19 December 2011 were largely driven by fear and panic. Stock pickers were rewarded for their fundamental analysis in the earlier bull market but failed to provide any meaningful return in the most recent crisis this was not unexpected, for when markets stop functioning as they did in 2008/2009 price discovery broke down. By hedging on the downside, HF managers are able to lower their overall risk profile leading to lower volatility and greater diversification for investor portfolios. When comparing Equity Hedge risk to equity market risk, they appeared to be almost 45% less. These results reiterate the important role of having a low Beta and the potential for Alpha generation, when compared to passive long only equity index replication. In summary, we conclude that HFs have performed better than the equity market in drawdown periods. This outperformance however has little to do with superior market timing abilities; we were not able to conclusively establish that they increased their Beta exposures ahead of market rises or decrease their Beta before market falls. Rather, their outperformance is a function of their hedged characteristic being hedged; they do not rely on market exposure to create returns, which protects them in falling markets. Do Hedge Funds create Alpha in Bull Markets? We isolated three periods of rising returns, these being from January 1993 August 2000, October 2002 October 2007, and March 2009 October The first and the most recent period data can be viewed in the appendix. We believe it is too premature to analyze the returns from the most recent 2 years as an indication of long term performance. From the data in Figure 11, we can see significant upside appreciation during rising equity markets. As noted in the commentary earlier, security selection and not market timing is the main Alpha generator during these successful times. Market timing actually reduced performance during these rallies while security selection provided an equal amount of return as Beta exposure. This demonstrates that there is skill generating the excess returns opposed to solely Beta exposure. HFRI Equity Hedge index captured 78% of the upside with 56% of the equity market risk. By analyzing the Information Ratio, or the Alpha risk adjusted return, the HFRI EH Index outperformed the broader markets. The results establish that even if the upside is only capturing a portion of the rally, EH is a superior investment option due to its decreased risk profile. Figure 11: Bull Market Returns (10/ ) Security Selection M arket Timing Beta Return HFRI EH (Total) S&P -0.4% 4.9% 5.0% 9.6% 12.2% -2% 0% 2% 4% 6% 8% 10% 12% 14% Source: Hedge Fund Research, UBS Al Figure 12: Bull Market Risks (10/ ) Security Selection Market Timing Beta Return HFRI EH (Total) S&P 1.5% 3.6% 4.0% 5.5% 9.7% 0% 2% 4% 6% 8% 10% 12% Source: Hedge Fund Research, UBS Al Figure 13: Bull Market Information Ratio (10/ ) Security Selection M arket Timing HFRI EH (Total) S&P Source: Hedge Fund Research, UBS Al

78 UBS Alternative Investments 19 December 2011 Implications of Absence of Market Timing Alpha Conventional wisdom views market timing ability with a healthy dose of skepticism, and our analysis supports this view. However in some ways, this result may seem surprising. After all, why should timing markets be harder than selecting securities? There might be at least two reasons for this result. First, HFs in general may be focused much more on security selection than on market timing. To the extent that market timing decisions are implicit, or unrelated to a manager s views about a particular market, we would expect market timing to increase risk without a commensurate increase in return. Second, even managers who have some market timing ability will have difficulty demonstrating this ability across just one or two markets, when the market timing component of their strategies may lack sufficient breadth. The fundamental law of active management states that a manager s Information Ratio depends on the quality of his forecasts, as well as on the breadth of the investment strategy (i.e., the number of independent investment decisions he makes). Even a highly skilled manager will have trouble generating a high Information Ratio if he only makes timing decisions across one or two markets. This becomes more obvious when analyzing global macro strategies, which seemingly generates excess returns through market timing, as they focus on multiple markets and underlying instruments. Although the reason why HFs have historically detracted value through market timing is unclear, the implications for investors are relatively straightforward. Either HF managers are poor market timers, or they do not actively manage their exposures to different markets. In either case, investors cannot rely on HF managers to avoid large corrections in the markets that they trade. Investors may also want to consider more actively managing their market exposures to offset the risks that HF managers generate by changing their Betas over time. Conclusion With reduced long-term return expectations for traditional assets, HFs, often perceived as a pure form of active management, have drawn increasing investor attention. HF managers have a great deal of freedom in exploiting trading approaches and utilize that freedom to change their strategy in order to capitalize on opportunities as they see them. It is precisely this freedom to actively manage their portfolio that has been viewed by many as the primary advantage HFs have over more traditional styles of active management; indeed, investors often want their managers to access opportunities where they see them. That said, this freer form of active management is not without its costs. To the extent that HF managers can employ dynamic trading strategies, and have more flexibility to execute market timing, it is important for both managers and investors to understand the risks they are exposed to; and whether those risks are ones that generate returns. In this paper we provided a Kalman Filter based framework to better understand and measure Active Beta - the changing exposures that HFs have to underlying market factors in a more rigorous manner. We compared the returns from a manager s average market exposures to the returns from the manager s time varying market exposures to separately determine Alpha or value added from market timing and security selection. We explored the properties of HF Alpha and highlight implications. We conclude that HF managers, as an industry, have demonstrated near persistent ability to create skills based returns in almost all market environments through security selection. 14

79 UBS Alternative Investments 19 December 2011 Appendix: Hedge Fund Alpha in Bull Markets Figure A1: Bull Market Returns (01/93-08/00) Figure A2: Bull Market Returns (03/09-10/11) Security Selection 11.6% Security Selection 2.3% M arket Timing -0.7% Market Timing -0.6% Beta Return 6.1% Beta Return 9.8% HFRI EH (Total) 17.0% HFRI EH (Total) 11.6% 23.7% S&P 14.7% S&P -5% 0% 5% 10% 15% 20% -5% 0% 5% 10% 15% 20% 25% Source: Hedge Fund Research, UBS Al Source: Hedge Fund Research, UBS Al Figure A3: Bull Market Risks (01/93-08/00) Figure A4: Bull Market Risks (03/09-10/11) Security Selection 6.9% Security Selection 3.4% Market Timing 1.9% Market Timing 1.8% Beta Return 5.5% Beta Return 7.3% HFRI EH (Total) 9.5% HFRI EH (Total) 9.9% 17.5% S&P 13.2% S&P 0% 2% 4% 6% 8% 10% 12% 14% Source: Hedge Fund Research, UBS Al 0% 5% 10% 15% 20% Source: Hedge Fund Research, UBS Al Figure A5: Bull Market Information Ratio (01/93-08/00) Figure A6: Bull Market Information Ratio (03/09-10/11) Security Selection 1.7 Security Selection 0.7 Market Timing -0.3 Market Timing -0.3 HFRI EH (Total) 1.8 HFRI EH (Total) 1.2 S&P 1.1 S&P Source: Hedge Fund Research, UBS Al Source: Hedge Fund Research, UBS Al 15

80 UBS Alternative Investments 19 December 2011 Alternative Investment Funds Risk Disclosure Interests of Alternative Investment Funds (the Funds ) are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of the Funds, and which Clients are urged to read carefully before subscribing and retain. This communication is confidential, is intended solely for the information of the person to whom it has been delivered, and should not be reproduced or otherwise distributed, in whole or in part, to third parties. This is not an offer to sell any interests of any Fund, and is not a solicitation of an offer to purchase them. An investment in a Fund is speculative and involves significant risks. The Funds are not mutual funds and are not subject to the same regulatory requirements as mutual funds. The Funds' performance may be volatile, and investors may lose all or a substantial amount of their investment in a Fund. The Funds may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Interests of the Funds typically will be illiquid and subject to restrictions on transfer. The Funds may not be required to provide periodic pricing or valuation information to investors. Fund investment programs generally involve complex tax strategies and there may be delays in distributing tax information to investors. The Funds are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits. The Funds may fluctuate in value. An investment in the Funds is long-term, there is generally no secondary market for the interests of the Fund, and none is expected to develop. Interests in the Funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period of time before making an investment in a Fund. Investors should consider a Fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, there are risks specifically associated with investing in hedge funds, which may include those associated with investing in short sales, options, small-cap stocks, junk bonds, derivatives, distressed securities, non-u.s. securities and illiquid investments. This document is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS Financial Services Inc. has no obligation to update such opinion or information. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 16

81 UBS Alternative Investments 22 November 2010 Private Equity Education Series Part 1: What is Private Equity? Reports in this series Report Highlights Page Part 1: What is Private Equity (PE)? Private equity basics 1 How large is private equity as an asset class? 2 What are typical requirements to invest in PE? 2 How do private equity funds work? 3 Carried interest calculation 5 Conclusion and outlook 5 Part 2: Investing in Private Equity Part 3: Private Equity Strategies Part 4: PE Portfolio Construction & Performance Measurement This primer is designed to assist investors in furthering their understanding of private equity fund investing. It explains the basics of private equity as an asset class, the pros and cons of making such investments, highlights popular sub-sectors and points out salient considerations in portfolio construction and performance measurement. It is intended to serve as a practitioner's quick guide to private equity fund investing. Investing in a private equity fund is often labor intensive as the term private itself implies a space that is information starved. Newcomers to this space are at a disadvantage as the industry is relationship-based and some of the best funds are hard to identify and often tend to be oversubscribed. It is also difficult to create small, diversified portfolios as minimums to access funds are often greater than what individual high-net-worth investors are able, willing, or ought to commit. Moreover private equity itself is a very broad asset class, encompassing many sub-sectors such as venture capital, turnaround investing, special situations, various types of leveraged buyouts, mezzanine, international and emerging markets. This variety within private equity can itself be a source of confusion. Yet, the benefits of adding private equity to an investment portfolio can be substantial. It is therefore worthwhile to develop a solid understanding of the merits of private equity investing as well as the issues and risks involved. Private equity basics Private equity funds pursue a business model that is based on acquiring control of companies to increase the market value of their pooled capital through active engagement and then exiting at a later stage at a profit. This engagement may include demands for changes in management, the composition of the board, dividend policies, company strategy, company capital structure and acquisition/disposal plans. Private equity funds sometimes also take public companies private for a period of restructuring before either returning it to public ownership or by selling it to another company or fund. Property and infrastructure funds are often included within the definition. Generally, these funds are set up to buy infrastructure or property-based companies that deliver both capital gains and long-term predictable cash flows. UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information.

82 UBS Alternative Investments 22 November 2010 Private equity offers the opportunity to share in the development of companies that have the potential to achieve above-average growth. Managers of private equity investments work in partnership with the firms they invest in to create value by growing revenues and profits as well as optimizing the capital structure. Ultimately, it is largely the collaboration between firm management and private equity managers that determine a company s destiny, and not the vagaries of the stock market. Given the specific characteristics of the private equity market, fund manager skills have a more significant impact on fund returns than is the case for funds investing in public securities markets. In public markets, a great deal of company information is freely or at least easily available and is therefore by and large incorporated in asset prices. In contrast, in private equity, information is largely private. Fund managers must therefore have a much more hands-on approach to selecting companies and interacting with their management. This greater effort, however, allows fund managers to capture economic rents that would not be available in an investment space with readily available public information. Another related feature, the long-term nature of private equity investments, allows investors enough time to implement and effect fundamental and lasting changes. In addition to this, private equity arrangements include compensation structures that strongly incentivize company executives as well as private equity managers to achieve attractive returns for their investors. Private equity funded firms tend to exhibit corporate governance that better align the interests of investors and management. These are features that can help drive value creation and performance. Private equity is sometimes perceived to be a higher-risk, high-return asset class. The perception of higher risk stems from its traditional close association with venture capital - the making of equity investments in young companies with strong potential for growth, often provided pre-revenue and usually pre-profit- which is a riskier sub-sector of the asset class. However, investing in a risky start-up company is but one small segment of the private equity market. By far, the largest part of the private equity sector involves buyouts of established companies with solid customer bases, proven products and quality management. Other sub-sectors include control oriented distressed investing, providing mezzanine financing, supplying growth capital and implementing variants of special situation opportunistic investing. Generally, private equity funds have the following characteristics: an intended limited life of years; no continuous capital raising during the life of the fund, as investments are made from calling on capital already committed by their investors; illiquid investments and no requirement to redeem investors' interests upon their requests; no routine acquisition of listed securities or derivatives as the focus of their investment strategy. To summarize, the investment strategy of private equity funds is characterized by the deployment of equity capital targeting investments for financial returns arising out of long-term capital appreciation. Many of their investee companies are unlisted firms, a sector that generally has limited access to bank and capital market financing. The private equity industry also provides an important source of growth capital for small companies for business expansion (including capital expenditure, working capital and strategic acquisition), management buyout and re-capitalization. Exits from investments are through a listing of the shares of the investee company or strategic sale and, to a lesser extent, through structured sale such as the buyback of the fund's equity interest by the investee company or its other shareholders. In addition, during the investment holding period, private equity fund managers add value to investee companies through instilling corporate governance, providing advice on financial, strategic and operational matters, as well as strengthening management teams. How large is private equity as an asset class? Private equity is still a small asset class compared to listed equities and fixed income markets. In the wake of the financial crisis, the amount of fundraising by private equity funds declined substantially (see Figure 1). Nonetheless, globally around $2.5 trillion of capital has been raised and cumulatively deployed through fund investments. In addition, we estimate that at the end of 2010 around $400 billion of committed, but uncalled, capital will remain. While these amounts may appear substantial, they pale in comparison with the global market capitalization of listed stocks, which stood at $50 trillion as of September What are the typical requirements to invest in private equity? High net worth and Family offices have been traditional participants in this space and remain a key part of the investor community. 2

83 UBS Alternative Investments 22 November 2010 Figure 1: Private equity global fundraising Capital raised by quarter (01/01/ /30/2010, in billions of dollars) Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Source: Pregin (2010) Figure 2: Private investors account for nearly a fifth of the private equity market Private equity investor base as of 2009 Fund of funds 13% High net worth investors & Family offices 19% Endowments / foundations 9% Other 4% Insurance cos 10% Source: BCG, Hennessey, Preqin, 2009 Pension funds 37% Banks & financial services 8% Partners in their partnerships; otherwise, they can accept a maximum of 99 Limited Partners. Under Regulation D of the Securities and Exchange Commission's rules, which governs the private placement of funds, private equity firms under most circumstances cannot have more than 35 unaccredited investors as Limited Partners. To be accredited, an individual investor must have a net worth of $1 million (or joint net worth with spouse), or have made at least $200,000 in each of the prior two years (or joint income with spouse of at least $300,000), and have a reasonable expectation of making at least the same amount next year. How do private equity funds work? Structure Private equity funds typically are structured as private Limited Partnerships. The individual managers of a fund make up the General Partner. The named General Partner entity in the partnership tends to be a limited liability corporation. The General Partners of the partnership are responsible for the day to day management of the partnership s investment, as well as general liability for any lawsuit that may be brought against the fund. Partnerships are preferred investment structures because of their ability to accommodate both pension and non-pension investors, favorable tax treatment, well-established legal precedent and familiarity. The Limited Partners of the partnership are the investors, i.e., the main providers of capital. These are typically wealthy individuals, endowments, pension funds, and other institutional investors. They must not be actively involved in the day-to-day operations of the funds if they are to maintain limited liability status (see Figure 3). Figure 3: Structure of a private equity fund The minimum commitments that private equity firms set for their funds generally run from $5 million to $20 million. Fund of fund managers (described later in the series) generally set minimum commitments in the $250,000 to $500,000 range for individuals, and at significantly higher levels for institutions. At their discretion, General Partners can make exceptions to these minimum commitments, and they often do. Amendments made in 1996 to The Investment Company Act of 1940 in the United States give private equity firms an incentive to accept individual investors if they have investable assets of $5 million or more, and institutional investors if they have investable assets of $25 million. The incentive is that private equity firms can accept up to 499 so-called "qualified investors" as Limited Limited Partner General Partner Companies Source: UBS Insurance Company Company A Pension Large HNWI Fund Corporate The PE Fund Company Company Company B C D Other Manager Company E 3

84 UBS Alternative Investments 22 November 2010 An important element of limited partnerships is that the General Partners also commit investment capital to the fund. This ensures that mutual interests are well aligned. Private equity partnership agreements signed by the parties involved govern the actions, and carve out the roles, of both the General and Limited Partners. Agreements typically provide for an investment period of five to seven years, and for a partnership term of 10 to 12 years. Capital drawdown and distribution General Partners of a fund draw down capital from the Limited Partners as and when they make investments. General Partners call down capital only as they require it, rather than in pre-set amounts according to a rigid timetable. If an investor fails to fund a capital call from a fund when due, the fund may exercise various remedies with respect to such investors to forfeit, or sell, all or a portion, of its interest in the fund or requiring that the investor immediately pay up the full amount of their remaining capital commitment. Cash or stock is returned to Limited Partners after the General Partner has exited from an investment. Stock distributions are sometimes referred to as "in-kind" distributions. The partnership agreement governs the timing of distributions to the Limited Partner. Fees, profit sharing and incentive alignment between general and limited partners While fees and profit sharing (carried interest) may occasionally vary across partnerships, the "2-and-20" structure is the most prevalent. 2-and-20 means that the annual management fee is 2% of the committed capital, and when final investment gains are realized, 20% of the profits go to the General Partner as their profit share. The fee structure for private equity funds sources of income for the General Partner comprises a variety of different component parts, including, but not always limited to all of the following: Management fee These payments are typically set at approximately 1% - 2% of committed capital during the initial investment period (of about five years). These payments then usually fall back to a lower percentage of the total of un-drawn capital plus the acquisition cost of investments still held (i.e., excluding capital already returned to investors). The fees are usually payable from the outset of the fund s life. To avoid individual funds being churned to increase management fees, the fee may be reduced further or removed if a younger concurrent fund is set up. Transaction fees These can amount to 0.5% to 1% of deal enterprise value. These fees represent a success fee for identifying and completing a transaction. Such fees are usually credited to the fund or split with the fund and the General Partner on a prearranged basis. Abort fees (i.e., fees to recover expenses involved in deals which are eventually not consummated) traditionally have been charged to the fund. However, this can be a point of negotiation between the Limited and General Partners, with Limited Partners increasingly seeking to have abort costs netted against transaction fees. Monitoring fees These may be charged for continuing to ensure that the transformation process of a company acquired by the fund is going according to plan. These tend to be relatively small and are increasingly uncommon. Carried interest This is a performance fee sharing arrangement and usually equates to 20% of capital gains. This is typically not paid out until Limited Partners capital has been returned and a specified rate of return on their investment has been achieved. This is designed to incentivize the fund manager but delays the moment at which a fund becomes profitable from the fund manager s perspective. Figure 4: Private equity compensation illustration Profit Sharing Management Fee Source: UBS 8% Hurdle Rate Net Cash Flows Limited Partner General Partner

85 UBS Alternative Investments 22 November 2010 Carried interest calculation Calculation of carried interest varies, and it is important to understand how this is arrived at. The industry has evolved from a deal-by-deal calculation of carried interest to the aggregation method. Previously, the carried interest was based on individual portfolio deals where deal-by-deal carried interest allowed General Partners to receive carried interest from profitable deals without being penalized for unprofitable deals. As such, deal-by-deal carried interest created a temptation for General Partners to concentrate on strong performing companies while neglecting mediocre performers. To align the interest of the Limited and General Partners, deal-by-deal accounting has been virtually eliminated. Hurdle Most contracts today include a provision referred to as the hurdle, or preferred rate, which requires that the investments achieve a minimum rate of return before the General Partnership receives its carried interest. This implies that a return beyond the Limited Partners capital contribution must be achieved before the General Partner can share in the profitability of the investment. The hurdle rate is intended to align the interests of the General and Limited Partners by giving the General Partner added incentive to outperform a traditional investment benchmark. Hurdle rates typically range from 5% to 10%. Clawback These are look back provisions which allow for a review of the total profit distribution from the partnership at the end of the term. The purpose of a clawback is to provide assurance that Limited Partners have received their capital contribution, the fees they have paid, and a prespecified hurdle rate of return before any carried interest is shared. Additionally, the clawback is a mechanism to recapture overpayments to the General Partners if they received more than their stated carried interest. Conclusion and outlook In summary, private equity is an illiquid long-term asset class, which, when approached with the necessary expertise, has the potential to improve the risk / return characteristics of an investment portfolio. Properly included, private equity complements listed equity portfolios and has the potential to provide a different source of return, enhance diversification and lower volatility. Private equity is heterogeneous and includes several sub-sectors, all of which have their own unique characteristics. Given large dispersion of returns across private equity managers and a degree of performance persistence, manager selection is of critical importance. The following installments in this series of reports will expand on the benefits and risks of investing in private equity, highlight the salient differences between the various existing sub-sectors of the private equity world, and address a number of important portfolio construction and performance measurement issues that investors need to be aware of. 5

86 UBS Alternative Investments 1 December 2010 Private Equity Education Series Part 2: Investing in Private Equity Reports in this series Report Highlights Part 1: What is Private Equity (PE)? Part 2: Investing in Private Equity Why invest in private equity? 1 What are some risks in private equity investing? 3 Growing secondary market 4 Part 3: Private Equity Strategies Part 4: PE Portfolio Construction & Performance Measurement Page UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. Having discussed the fundamentals of private equity in the first part of the series, this installment highlights some advantages of investing in private equity, as well as some of the risks involved. The fundamental reason for investing in private equity is to improve the risk and reward characteristics of an investment portfolio. Studies have shown that private equity returns do not correlate closely with returns from other asset classes, such as bonds and in certain cases public equities. Having an allocation to private equity therefore may help smooth out the returns of a balanced portfolio as well as provide additional sources of returns. Why invest in private equity? Source of long-term returns If one considers available historical statistics, it becomes clear that the advantages of private equity investments must be viewed over the long term. Figures 1 and 2 show the average returns of private equity as an asset class. There is significant dispersion in these numbers between top quartile performing managers and the average for the asset class. As illustrated in Figure 1, at the end of 2007, (before the distortions induced by the financial crisis) the average longterm return was around 10.7% over a 10-year period. During 2008, as was the case with almost all other assets, valuations of unlisted businesses plunged, and distributions to investors came to a near standstill. After the crisis ebbed, valuations began returning to more normal levels as reflected in figure 2. The positive 1-year returns in Figure 2 reflect a swift bounce-back in valuations in 2009 vs

87 UBS Alternative Investments 1 December 2010 Figure 1: Internal Rate of Return (IRR) % (Annualized) Performance through December 31, 2007 Calculation Type : Pooled IRR Primary Market Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr All Venture Small Buyouts Med Buyouts Large Buyouts Mega Buyouts All Buyouts Mezzanine Buyouts and Other PE All Private Equity Source: Thomson Venture Economics PE = Private Equity Figure 2: Internal Rate of Return (IRR) % (Annualized) Performance through March 31, 2010 Calculation Type : Pooled IRR Primary Market : Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr All Venture Small Buyouts Med Buyouts Large Buyouts Mega Buyouts All Buyouts Mezzanine Buyouts and Other PE All Private Equity Source: Thomson Venture Economics The Private Equity Performance Index is based on statistics from Thomson Venture Economics Private Equity Performance Database, analyzing the cash flows and returns for over 1,750 US venture capital and private equity partnerships with a capitalization of $585 billion. Sources are financial documents and schedules from Limited Partners investors and General Partners. All returns are calculated by Thomson Venture Economics from the underlying financial cash flows. Returns are net to investors after management fees and carried interest. Buyout funds sizes are defined as the following: Small: $0 - $250 million, Medium: $250 - $500 million, Large: $500 - $1,000 million, Mega: $1 billion and over. Past performance does not guarantee future results. Access to selected opportunities in low macroeconomic growth environments In an environment in which growth in developed economies is expected to fall short of what we have seen in recent decades, seeking growth opportunities will be paramount. Successful private equity managers pick companies with growth potential and actively create the conditions for growth. In some cases, private equity funds own large controlling stakes in companies, with few (except for syndicated deals) other private equity managers having access to the same companies. This contrasts with mutual funds, which often hold largely the same underlying investments as their peer group, with variations in weightings being fine-tuned to a few basis points. Potential to create absolute returns Private equity is oriented toward generating absolute investment returns rather than beating a benchmark index. Excessive volatility and poor investment performance experienced by quoted equity portfolios, many of which have index-tracking strategies or are benchmarked to an index, have led to a swing in favor of strategies that seek absolute returns. Private equity managers do seek absolute returns and their traditional incentive structure, the "carried interest" (described in Part 1 of this series), is highly geared toward achieving net cash returns for investors. Improved risk and volatility characteristics Within a balanced portfolio, the introduction of private equity can improve diversification. Lower correlation of returns among some sub-sectors of private equity and public market classes remain an important feature of the asset class, and properly constructed portfolios therefore have the potential to reduce overall volatility. Exposure to the smaller companies market The private equity industry has brought corporate governance to smaller companies and provides an attractive manner of gaining exposure to the small and mid-market growth sectors. It also offers the ability to gain investment exposure to the most entrepreneurial sectors of the economy. Has influence over management and flexibility of implementation Private equity managers generally seek active participation in a company's strategic direction, from the development of a business plan to selection of senior executives, the introduction of potential customers, M&A strategy and the identification of eventual acquirers of the business. Furthermore, implementation of the desired 2

88 UBS Alternative Investments 1 December 2010 strategy can normally be effected much more efficiently in the absence of public market scrutiny and regulation. Allows off balance sheet leverage Leveraged buyout fund managers (described in Part 3 of this series) in particular are able to make efficient use of leverage. They aim to organize each portfolio company's funding in the most efficient way, making full use of different borrowing options from senior secured debt, to mezzanine capital and high-yield debt. By organizing the company's funding requirements efficiently, equity returns are potentially enhanced. In addition, because the leverage is organized at the company level and not the fund level, there is a ringfencing benefit: if one portfolio company fails to repay its borrowing, the rest of the portfolio is not contaminated as a result. Thus the investor has the effective benefit of a leveraged portfolio with less downside risk. Figure 3: Advantages and risks of private equity Advantages Risks Source of long-term returns Long-term illiquid investments Access to growth opportunities Uncertain cash flows Potential for absolute reuturns "Blind pool" investing Improved portfolio risk/return characteristics Valuation risk Exposure to smaller company market Speculative investments Influence over management and flexibility of strategy implementation Possibility of off-balance sheet leverage Source: UBS Alternative Investments What are some risks in private equity investing? Private equity investing is not without risks, however. There are features of private equity investing that investors need to be aware of: Long-term illiquid investment Interests in private equity funds are generally not readily marketable and not redeemable. Interests are generally not transferable except in limited circumstances. Accordingly, investors have to bear the risks of investing in funds for their full duration. In general, holding periods between investment and realization can be expected to average three or more years. Because the underlying portfolio assets are less liquid, the structure of private equity funds is normally a closed-end structure, meaning that the investor has very limited or no ability to withdraw its investment during the fund's life. Private equity should therefore be viewed as a longer-term investment strategy even though there is a growing secondary market for investors seeking liquidity. In a certain sense, the illiquidity of private equity investments is one of the sources of return for investors. Private equity investors in effect expect to earn a liquidity premium for the investing commitments that they make. Uncertain cash flows An important feature related to illiquidity is the uncertainty surrounding the cash flows of private equity investments. The unpredictability of cash flows applies to both capital calls, which the investor must fulfil at earlier stages, and distributions to the investor at later stages. In both cases the amount and timing of cash flows is at the discretion of the fund manager. Investors needing cash flow predictability for cash flow management purposes must rely on other portions of their investment portfolio for such considerations. Hence, the importance of carefully considering cash flow needs in portfolios. "Blind pool" investing Investors do not know ex-ante what their funds will be invested in and rely on the skills and judgement of the private equity manager. Private equity fundraising is referred to as commitments because not all funding is made available immediately to the fund vehicle. Rather, funds are called up as projects covered by the private equity vehicle s mandate become available. When committing to a private equity fund, the commitment is typically to provide cash to the fund on short notice from the General Partner. While fund documentation will outline investment strategy and restrictions, investors give a very wide degree of discretion to managers to select the companies that they will have a share in. There is usually no 3

89 UBS Alternative Investments 1 December 2010 Growing Secondary Market Private equity investments are generally considered illiquid. There are no popular exchanges, as there are for publicly traded securities, on which to buy and sell interests in private equity funds. However there is a rapidly developing market in interests in existing private equity funds, referred to as "secondaries". A secondary offering may comprise a single manager's entire fund of direct investments or, more commonly, a portfolio of interests in a number of different funds; there are a growing number of dedicated investors that specialize in purchasing interests in existing funds from their original investors. Managers of secondary funds do not generally invest directly in companies, but rather in the private equity funds managed by buyout firms or venture capital firms. The big difference is that they are buying their interests in a fund after the fund has been at least partially deployed in underlying portfolio companies. So, unlike fund of fund managers, which generally invest in blind pools, secondary buyers can evaluate the underlying companies that they are indirectly investing in. For larger secondary portfolios, a buyer is commonly secured through an auction process. For smaller transactions, these are often affected in a confidential manner, sometimes with buyer and seller matched by the fund's manager or by an intermediary. One of the keys to a secondary transaction is securing the goodwill of the underlying General Partner. The fund manager often has the ability to refuse or restrict any transfer of interest. In addition, valuation of the underlying assets is facilitated by the co-operation of the manager. The secondary market remains a relatively small part of the private equity world 3% to 5% of the primary market. As institutional private equity programs increase and start to reach maturity, the ability for investors to realize some existing commitments in order to raise cash for future commitments will become more attractive. This will be an important factor that accelerates the development of the secondary market going forward. Secondaries are important to private equity investing because it allows investors to maintain the positive attributes of private equity investing while mitigating certain risks, such as investing in a blind pool of investments made by new managers. From a portfolio management perspective, exposure to Secondaries can reduce the length and severity of a portfolio s J-curve (described in Part 4 of the series). Additionally, the private equity market s illiquidity, combined with the liquidity needs of some sellers, often allows for a price discount from the fair market value of the fund. Buying into a private equity fund at a later stage in its life also results in earlier liquidity by shortening the holding period and the waiting period for distributions. ability at the launch of a private equity fund to preview portfolio assets before committing, because they have not yet been identified (except in a few cases where potential investments have been warehoused). Also, there is generally no ability to be excused from a particular portfolio investment after the fund is established. Valuation risk As private equity funds generally will invest in securities that are not readily marketable, securities generally will be carried at the values provided to the fund or at cost. These valuation procedures are subjective in nature and do not conform to any particular industry standard (though they do take guidance from widely accepted practices) and may not reflect actual values at which investments are ultimately realized. Speculative investments The investment strategies utilized by managers may include speculative investment techniques, highly concentrated portfolios, non-control positions and illiquid investments. Moreover, in the case of specific strategies such as buyouts, significant amounts of leverage can be involved, which can improve returns in good times but amplify losses under adverse conditions. Because of the specialized nature of these investments, an investment in a private equity fund should be considered within a total portfolio context. 4

90 UBS Alternative Investments 13 December 2010 Private Equity Education Series Part 3: Private Equity Strategies Reports in this series Report Highlights Page Part 1: What is Private Equity (PE)? Part 2: Investing in Private Equity Part 3: Private Equity Strategies Leveraged buyouts 1 Venture capital 3 Mezzanine debt 3 Distressed investing 4 Special situations investing 5 Growth capital 5 Economic drivers of Private Equity strategies 5 Part 4: PE Portfolio Construction & Performance Measurement Private equity is an extremely heterogeneous asset class with many sub-sectors. These sub-sectors (e.g. distressed investing, different stages of buyouts and venture capital, mezzanine finance, special situations funds etc.) have very different asset characteristics. This means that each subsector has different performance drivers, which investors need to understand to make informed decisions. This installment of our private equity series highlights the most common private equity sub-sectors and describes their salient characteristics. Leveraged buyouts UBS Financial Services Inc. (UBS FS) is pleased to provide you with information about alternative investments. There are a few points we would like to raise with you at the outset. This article is for educational and informational purposes only. It does not constitute investment advice. Among other things, it does not take into account your personal financial situation, or your investment goals or strategies. You should not construe any information provided here to be an investment recommendation for you to follow. You should contact your Financial Advisor for information or recommendations that may be useful specifically to you. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness, and it may not be relied upon as such. Any opinions expressed or information provided in this document is subject to change without notice, and UBS FS has no obligation to update such opinion or information. Leveraged buyout (LBO) firms specialize in helping entrepreneurs to finance the purchase of established companies. The approach of such firms is to provide a management team with enough equity to make a small downpayment on the purchase of a business, and then to pay the rest of the purchase price with borrowed money (hence the term leveraged. A typical LBO is funded with four main types of capital: bank debt, high-yield bonds, mezzanine debt and equity. Bank debt may account for 50% of an LBO s funding, junk and mezzanine debt for 20% and equity around 30%. The assets of the business are used as collateral for the loans, and the cash-flow of the company is used to pay off the debt. The companies acquired are usually divisions being sold by corporations that are refocusing on their core businesses, or businesses owned by families that wish to cash out. To earn an attractive return on their investment, LBO firms build value in the companies they acquire. Typically, they do this by improving the acquired company's profitability, growing the acquired company's sales, purchasing related businesses and combining the pieces to make a bigger company, or some combination of these techniques. A popular technique is consolidation, aka "buy-and-build."

91 UBS Alternative Investments 13 December 2010 Figure 1: More equity required for LBO deals Average equity levels contributed, in % H 10 Source: S&P LCD Comps Figure 2: US buyout activity LBO volume ( , in billions of dollars) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q Source: S&P LCD Comps The mega and large buyout segments are expected to face several debt-related challenges in the next few years. The most significant include re-financing the wall of buyout debt due for repayment in , the more conservative capital structures required by the marketplace (greater equity requirements, see Figure 1), the limited availability of debt for new LBO investments and greater difficulties in bringing together debt syndicates. Middle market Generally defined as companies with revenues of $10 million - $250 million, assets of $200 million - $500 million and earnings before interest, taxes, depreciation, and amortization of less than $50 million, this market represents a large universe of potential target companies. Companies of this size usually share some common characteristics, such as seasoned management teams, proven business models, and critical size in terms of infrastructure. As going concerns, they are also frequently available at attractive entry price valuations. Targeting the middle-market space means situational investing in companies that have successfully grown to a size that minimizes the enterprise risk associated with smaller companies, but offer lower entry multiples relative to large-cap companies. Additionally, middle-market companies are generally small enough in the sense that they are not widely brokered by the corporate finance community therefore private equity funds can often acquire them with less price competition. Also, middlemarket companies that are going through distressed times tend to be more responsive to value-added initiatives. Lastly, investors in middle-market companies typically can pursue a variety of exit options, which often create opportunities to realize multiple expansions upon exit. The usual exit strategies for debt investors are to either "fix" a business (by restructuring it and implementing a turnaround strategy), divest it (sale of debt or equity), or liquidate it. The mega LBO segment within this sub-sector is by far the largest component of the private equity space. Prior to the financial crisis, one reason why the LBO market had grown so much was the readily available pool of debt financing. At the height of the LBO boom, in H1 2007, $606 billion worth of leveraged loans were issued, surpassing the amount originated in all of Also, because buyout firms were willing to band together into so-called club deals, the deals themselves had become larger. It has also been the segment most susceptible to the economic crisis though recent months have seen an uptick in both the volume and the number of mid-market deals, supported by larger equity contributions than in the period leading up to

92 UBS Alternative Investments 13 December 2010 Venture capital Risk capital for starting, expanding and acquiring companies is critical for any economy to grow. Preqin is a company that provides comprehensive data and research on private equity, real estate, hedge funds, infrastructure funds and other alternative investments. They estimate that "around 3,700 venture funds have raised $558 billion since 1998, with North America-focused funds consistently raising the most capital each year." Most are quite specialized, often investing in a single field, such as telecommunications or health care. Venture capital firms also tend to specialize by stage of investing. There are no hard and fast definitions for these stages. Broadly, however, seed-stage firms tend to provide a few hundred thousand dollars, and perhaps some office space, to an entrepreneur who needs to develop a business plan. These are the riskiest investments with the highest failure rates. Early-stage venture investors back companies at a point where they have a completed business plan, at least part of a management team in place, and perhaps a working prototype. Late-stage investors typically provide a second or third-round of financing, often of $2 million - $10 million or more, that funds production, sales and marketing, and carries the company into the revenue-producing stage. Mezzanine (or pre-ipo-stage) investors provide a final round of financing that helps carry the company to an initial public offering. Figure 3: Wide dispersion of returns across venture capital managers Manager quartiles for Internal Rate of Return (IRR, in %), all regions Top quartile Median Bottom quartile When investing in venture funds, it is important to be aware that the dispersion of returns between well-performing fund managers and laggards is especially pronounced (see Figure 3). Therefore access to the best managers, who are often capacity constrained, is a very important consideration. Mezzanine debt The mezzanine debt specialties of private equity share characteristics of both private debt and private equity financing. Mezzanine debt firms provide a middle level of financing in leveraged buyouts below the senior debt layer and above the equity layer. A typical mezzanine investment includes a loan to the borrower, in addition to the borrower's issuance of equity in the form of warrants, common stock, preferred stock, or some other equity investment. Often, the loan is contractually subordinated to a loan made by one or more senior secured lending institutions. Typically, the note evidencing the loan has a maturity of 6-10 years, with interest paid only during the first five years. Because the loan is subordinated, the interest rate is generally higher than the rate on the senior debt, and a limited amount of equity is issued to the mezzanine investor for nominal consideration. Mezzanine investments have been used extensively to help fund the purchase and recapitalization of private, middlemarket companies. Mezzanine investors also invest in smaller public companies and in foreign entities. Often, the borrower is highly leveraged after the investment is made. Because mezzanine investments include both debt and equity portions, mezzanine investors have defied the traditional classifications of lenders, on the one hand, and equity investors, on the other. The flexible financing nature allows a mezzanine investor to emphasize the capital preservation and current-pay features of a loan and, at the same time, seek significant upside on its investment through the equity participation. Source: Thomson One Banker: All Regions IRR as of June 30,

93 UBS Alternative Investments 13 December 2010 Distressed investing Over the past 20 years, distressed debt investing in the United States has become a mainstream investment strategy. The distressed debt market has increased in size with private equity firms and hedge funds now key players in this market. There are around 170 United States based, and Europe based credit managers who invest in distressed debt managing $120-$150 billion of private capital (hedge funds and private equity often they overlap). We estimate that, over the past few years, $50 to $70 billion has been raised by dedicated distressed middlemarket opportunity funds the bulk of which was in Traditional investors, who mainly seek to generate capital gains and investment returns through exposure to distressed debt investments, have been joined by strategic investors undertaking distressed M&A. As corporate, legal and capital structures have grown more complex, the level of expertise and differentiation in the style of investment has kept pace. Approaches to distressed debt investing include private equity-type structures practicing control-oriented 1 and restructuring 2 strategies as well as in hedge fund-type trading 3 and noncontrol 4 structures. Consistent with investment activity, public and corporate pension plans, endowments and foundations, as well as fund of funds have been large investors in the distressed sector. The middle-market space continues to bring compelling investment opportunities. These opportunities include: i) the 1 Control-oriented investing is largely practiced by private equity funds that generate returns by accumulating large distressed debt positions that allow them to acquire a position of control in bankruptcy proceedings they make active operational and managerial interventions. 2 Restructuring funds invest in financially distressed companies, but they do so by investing new equity in companies in order to take control. They are, for the most part, equity investors and not debt investors. 3 Trading-oriented strategies are largely the preserve of hedge funds. These funds generate returns by buying undervalued debt securities and have very short holding periods. purchase of companies that are distressed or out-of-favor, for low multiples of cash flow and/or low percentages of asset value; and, ii) the acquisition of quality companies with excessive leverage or those that are going through bankruptcy that requires restructuring. The economic and financial crisis has had a negative effect on the cost and availability of credit. This has further increased opportunities. The level of analytical sophistication, both financial and legal, necessary for successful investment in the space is unusually high, creating entry barriers for participants. Special bankruptcy situational investments are expected to be attractive segments for distressed investing. Figure 4: Opportunities, strategies in distressed investing Source: UBS Figure 5: Growth capital exhibits intermediate levels of risk and return High Return Potential Low Source: UBS Low Loans Buyout Growth Capital Probability of Loss Venture Late Stage Venture Early Stage High 4 Returns come from passively holding securities - where the value of securities is enhanced through active negotiations during the bankruptcy process. 4