Alternative Investment Strategies. Sponsored by:

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2 Alternative Investment Strategies Sponsored by:

3 Volatility = Risk? Fact or Myth Diversification provides superior long-term returns? All investment opportunities normalize and revert to the mean?

4 Is There a Hedge Fund Bubble? A trillion dollar industry - a world of 1,000 niches Multiple client agendas Performance oriented culture Market forces separate the wheat from the chaff

5 1 Combining Discipline with Flexibility Corporate Asset Classes Structures Debt Hybrids Equity Derivatives Other Long in Value Investing Short Hedged Arbitraged Other The space of opportunities for value investing has expanded enormously and the need for and the availability of flexibility has increased. 2 Understanding the payoff process and drivers Forecasting the nominal dollar amount of the payoffs Measuring the meaning, significance or utility of the payoffs Value investing emphasizes fundamental analysis of the payoffs from investment opportunities. We divide the analysis of payoffs into three key areas.

6 Combining Discipline with Flexibility in Value Investing 3 Buffett s bond/company analogy: stock company bond stock or bond company stock bond The technique of framing and reframing is at the core of the analytic process for dealing with payoffs because it provides flexibility within the discipline of value investing. 4 Game Theory Pricing Models Options Decision Models Return Models The toolbox and WAP approach (words, algebra and pictures) facilitates reframing by using decision analysis as the basic power tool and the other tools and concepts as attachments.

7 5 The wheel is a circular decision tree which puts all the above in the larger context of events and decisions affecting a value investor s efforts to construct a portfolio based on asset allocation, security selection and structuring strategies

8 Value investing as an investment philosophy and strategy emphasizes the return of money over the return on money. Practitioners of value investing seek to earn at least reasonable returns during normal times, preserve principal during disruptive periods, and put money to work during such disruptive periods which ultimately earns abnormal returns. If money is not lost, the cadence of normal and abnormal returns over time takes advantage of the power of compounding (which Albert Einstein supposedly said was one of the most significant forces in the Universe).

9 Effective value investing combines the discipline and commitment of a coherent investment philosophy and strategy with the flexibility of reframing. Buffett performs reframing, for example, with his bond/company analogy although he does not call it as such. A conceptual tool box and the WAP approach (words, algebra and pictures) can facilitate reframing and provide multiple perspectives for analyzing the basic components of investment opportunities: understanding the payoff process and drivers, forecasting the nominal dollar amount of the payoffs, and measuring the significance, meaning, or utility of the payoffs.

10 Accounting based valuation and the continuing value driver formulation can be used to reframe like Buffett by seeing a stock as partial ownership of a company and then as a bond and then back to a stock. Another example of reframing is Professor Greenwald's approach of segmenting pricing models to reflect a company's competitive advantage and franchise. We can compare this segmentation of the company's intrinsic price or value with the segments of the company's capital structure. The value segments can then be matched with the capital structure segments to help clarify the bet an investor is making.

11 Penman Analytical Framework for Accruals All Stocks and Flows for a Firm Net operating assets employed in operations generate operating revenue (by selling goods and services to customers) and incur operating expenses (by buying inputs from suppliers). Products and Input Markets The Firm Capital Markets Customers OR C F Debtholders or Debt Issuers Suppliers OE Net Operating Assets (NOA) I Net Financial Assets (NFA) d Shareholders OR - OE = OI OI - NOA = C - I C - I - NFA + NFI = d Operating Activities Financing Activities Key: F = Net cash flow to debtholders and issuers d = Net cash flow to shareholders C = Cash flow from operations I = Cash investment NFA = Net financial assets NOA = Net operating assets OR = Operating revenue OE = Operating expenses OI = Operating income NFI = Net financial income ( indicates change)

12 Operating and Financing Activities All Stocks and Flows Operating Activities (C - I) = OI - DNOA operations generate operating income and free cash flow is the part that remains after reinvesting some of it in net operating assets if investment in NOA > OI, free cash flow is negative if investment in NOA < OI, free cash flow is positive Financing Activities (C - I) = DNFA - NFI + d OR (C - I) = NFE - DNFO + d explains the disposition of free cash flow from operating activities (above), i.e. free cash flow and net financial income (expense) increase (decrease) net financial assets (obligations) and increase (decrease) payout of net dividends

13 Continuing Value (McKinsey) Model for Valuing Equity CV = (NOPLAT (1-g / ROIC)) / (WACC g) (2) NOPLAT = OI = 177 ROIC = RNOA = OI / NOA = 177 / 1,325 = 13.3% Assume WACC = 10% and g = 3% CV = (177 (1 0.03/0.133)) / ( ) = 1,958 Equity value = CV NFO = 1, = 1,658 (NOPLAT (1-g / ROIC)) = NOPLAT NOPLAT (g/roic) = OI - DNOA DNOA represents the amount of OI (or NOPLAT) required to invest back into the business in order to achieve the assumed growth rate of OI (or NOPLAT) In this case, DNOA = 177 (0.03/0.133) = 40 vs. actual DNOA = 70 Need to analyze changes in OA and OL items to better understand economic and growth opportunities (if DNOA applied to projects where ROIC > WACC, firm creates additional value and vice versa) Dupont analysis can yield insight into value drivers and wealth creation (destruction) (2) NOPLAT = Net operating profit less adjusted taxes

14 DuPont Analysis - Break-down of Value Drivers ROCE = Earnings/CSE = RNOA + (FLEV x SPREAD) NFO FLEV = CSE SPREAD = RNOA - NBC Level 1 RNOA = OI/NOA = ROOA + (OLLEV x OLSPREAD) RNOA NFE NBC = NFO Level 2 PM = OI/Sales ATO = Sales/NOA Level 3 Sales PM Other items PM Gross margin ratios Expense ratios Other OI/ Sales ratios Individual asset and liability turnovers Borrowing cost drivers Ratios: ROCE = Return on common equity RNOA = Return on net operating assets ROOA = Return on operating assets NBC = Net borrowing costs Financial Earnings = Comprehensive income OLLEV = Operating liability leverage statement CSE = Common shareholders equity OLSPREAD = Operating liability leverage spread line items: OI = Operating income (after tax) FLEV = Financial leverage NOA = Net operating assets SPREAD = Operating spread NFE = Net financial expense PM = Operating profit margin NFO = Net financial obligations ATO = Asset turnover (1) Adapted from Penman, Financial Statement Analysis and Security Valuation, 2 nd Edition, 2004

15 Correlation of Returns by Strategy Bond Arb Event Driven Mkt. Neut Emerg. Mkts All Global Macro 0.31 Global Macro 0.31 Bond Arb Event Driven 0.57 All 0.33 Mkt. Neutral 0.58 Long/Short 0.59 Emerg. Mkts Long/ Short 0.06 Multi strategy 0.56 Risk Arb Multi strategy Distress.

16 Hedge Fund Returns by Strategy Index, 1994= All Emerging Mkts 250 Distressed Event Driven

17 Hedge Fund Returns by Strategy Index, 1994= Risk Arb Long/Short 250 Global Macro Equity Mkt Neutral

18 Correlation of Strategies with Broad Hedge Index Returns 18 month rolling correlation Risk Arb Global Macro Long/Short

19 Correlation of Strategies with Broad Hedge Index Returns 18 month rolling correlation Bond Arb Distressed Emerg. Mkts

20 Why Invest in Hedge Funds Absolute Performance - Hedge Funds attempt to produce consistent absolute returns regardless of the market direction. Focus on Risk Management - Hedge Fund Managers focus on preserving capital by carefully managing investment risks. Hedge Fund Managers often heavily invested in their own funds Greater Diversification - Funds of Hedge Funds add a further dimension of risk management, investor discipline and access to a diversified portfolio. Lower Volatility - The combined focus on absolute performance, risk management and diversification lead to a low volatility of performance.

21 Comparative Risk Adjusted Returns Annualized Return 16% (January 1990-February 2005) Hedge Funds 12% 8% 4% Lehman Agg. Bond Index 90 Day T-Bill Gov't Bonds 1-5Yr HY Bonds S&P 500 MSCI World Index 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% Risk (Standard Deviation)

22 Historical Hedge Fund Performance (1990- Feb 2005) Jan 1990 = Historically, Hedge Funds have Outperformed both Equity and Bond Indices. 4 Hedge Fund Composite S&P Lehman Brothers Agg. Bond Index

23 Composite Risk Adjusted Performance Risk vs. Reward Analysis of Hedge Fund Strategies ( ) Annualized Return 20% 16% Convertible Arb Distressed Securities Event Driven Long/Short Equity Emerging Mkts 12% 8% 4% Equity Market Neutral Relative Value Merger Arb Lehman Agg. Bond Fixed Income Arb Hedge Fund Composite S&P 500 MSCI World Index 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Risk (Standard Deviation)

24 Historical Hedge Fund Asset Growth US$ Billions

25 Looming Risks to Fixed Income Rising interest rates Telegraphed by the Fed Increasing default rates Default rates abnormally low last 4 years Undue pressure to chase yield Spreads are the lowest in modern history

26 Impact of Losses on Overall Return The Importance of Protecting the Downside Hypothetical Fixed Return Annual Return Value of Investment $1,000, Annual Return S&P 500 Value of Investment $1,000, % $1,065, % $908, % $1,134, % $800, % $1,207, % $623, % $1,286, % $802, % $1,370, % $890, % $1,459, % $1,459,142.30

27 Demonstrated Impact of Alternative Investments

28 Percent Alternative Strategies Asset Mix Trends for Endowments FY 2000 FY 2001 FY 2002 FY 2003 FY Hedge Funds Venture Capital Private Equity Energy & Natural Resources Private/Public Equity Real Estate

29 Allocations by Asset Classes 100% 80% 60% 40% Dom. Equities Fixed Income Intl. Equities Short Term Securities/Cash Alternatives Hedge Funds % % > $1B $500M - $1B $100M - $500M $50M - $100M $10M - $50M $0M - $10M

30 Yale Performance Relative to Benchmarks (10 Years) Yale Returns Active Benchmark Passive Benchmark Yale Returns 16.8 $<1B 12.5 $100M - 500M Domestic Equities Domestic Bonds Absolute Return Foreign Equities Private Equities Real Assets 10 Year Performance 4.6% CAGR Difference Between Domestic Bonds and Absolute Performance. Active Benchmarks: Domestic Equity: Frank Russell Median Manager, U.S. Equity Fixed income: Frank Russell Median Manager, Fixed Income Absolute Return: CSFB Composite Foreign Equity: Frank Russell Median Manager Composite, Foreign Equity Private Equity: Cambridge Associates Composite Real Assets: NCREIF and Cambridge Associates Composite Passive Benchmarks: Domestic Equity: Wilshire 5000 Fixed income: Lehman Brothers U.S. Treasury Index Absolute Return: 1-year Constant Maturity Treasure +6% Foreign Equity: 50% MSCI EAFE Index, 50% MSCI EM Index Private Equity: University Inflation +10% Real Assets: University Inflation +6%

31 Asset Allocations Domestic Equity Fixed Income Absolute Return Foreign Equity Private Equity Real Estates Cash Educational Institutions (%) Yale University (%)

32 Sources of Hedge Funds $66 billion of Institutional Money 2003 Q4 Private Plans 22% Other 7% Public Plans 18% Endowments and Foundations 53%

33 Institutional Investors Top Concerns About Hedge Funds Transparency 15% Fees 13% Impact of capital flows on returns 34% Headline risk 38%

34 Institutional Investors Views on Impact of Capital Flows on Returns No impact 24% Slightly negative 33% Significantly negative 43%

35 What is a Hedge Fund? The term "hedge fund" is not formally defined by federal securities laws The term usually refers to an investment entity that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act.

36 The Origin of Hedge Funds The first hedge funds appeared in the 1950s, and were characteristically long/short equity funds that engaged in fundamental hedging strategies.

37 Investors in Hedge Funds Hedge funds generally sell interests in private offerings to accredited investors. Accredited investors are individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth and most institutions with $5 million in assets.

38 Likely Impact of Registration of Hedge Fund Advisors If hedge fund advisers were compelled to register under the Advisors Act The SEC would be authorized to collect information about the activities of hedge fund advisers and hedge funds, It would increase the minimum investment requirement for direct investments as registered advisers are generally prohibited from charging performance fees unless investors have $750,000 invested with the adviser or have a net worth of $1.5 million.

39 Hedge Fund Index 10 Yr Returns % Annualized Return (93-04) Global Macro Distressed Long/Short Equity Event Driven CSFB/Tremont Hedge Index

40 Hedge Fund Index 10 Yr Volatility % Annualized Std. Dev Equity Mkt Neutral Fixed Inc. Arb Risk Arb. Multi- Strat. Convert. Arb.

41 Beta 0.55 Hedge Fund Indices Beta Emerg. Mkts Long/Short Equity CSFB/ Tremont Hedge Index Distressed Event Driven

42 Hedge Fund Indices Sharpe Ratio Sharpe Ratio Equity Mkt. Neutral Distressed Convt. Arb. Multi Strat. Event Driven

43 Flattening Yield Curve Percent March 31, September 30, 2004 March 31, M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y

44 Examples of Hedge Fund Trades Long/Short Equity - Preserving Gains: Stock A is owned at $5.00 a share and the shares increase in value to $15.00 per share, the fund can preserve its gains and limit its losses by selling the shares and purchasing calls at $17.00 for $2.00. The Fund has therefore locked in an $8.00 profit and limited it s loss to $2.00. Convertible Arbitrage: Company A s common stock trades at $10.00 per share; they have convertible bonds convertible at $10.00 and pay a 6% coupon. The Convertible Bond Fund Manager purchases $1mm bonds and sells short $1mm shares at $ The Fund will now collect the 6% coupon plus the interest on the short rebate (e.g., a broker rate) of 1.5%. The manager has generated an annualized return of 7.5%.

45 US$ trillions 20 Global Futures Market Notional Amounts US$ billions Interest Rate (L) Currency (R) Equity Index (R)

46 US$ trillions 25 Global Options Market Notional Amounts US$ billions Currency (R) Interest Rate (L) Equity Index (L)

47 Percent 10 8 Interest Rates Fed Funds Rate and the 10-year Treasury Fed Funds Rate 10-Year Government Bond

48 U.S. Trillions Jan 2000 = Trade Deficit and US Dollar Cumulative Trade Deficit Since 1985 (L) Yen/Dollar (R) Euro/Dollar (R) $4.8 trillions as of 2004Q

49 Lower Dollar, Higher Oil Price Jan 2000 = 100 Jan 2000 = Crude Oil Trade-weighted dollar

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