Investing in Hedge Funds

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1 The aim of investing in hedge funds is to gain exposure to some actively managed strategies that delivers exceptional returns uncorrelated to other investment strategies. An investment in hedge funds could be carried out in three ways: 1. it could be a part of an asset allocation process where hedge funds are combined with traditional or other alternative investments, or 2. the portfolio could be constructed only with single hedge funds based on fund of hedge funds investing principles, or 3. it could be a result of a direct investment in a single hedge fund manager company as a seed-investor. In all three cases it is important to understand that hedge funds are not a homogenous asset class and that every single hedge fund has its unique and often instable risk-return profile. Therefore every investment in hedge funds should be based on disciplined but creative investment process with an efficient and integrated risk management. Essential part of this investment process is to understand the investment strategy and its operational environment and to gain a clear picture of why this strategy should or should not continue to produce exceptional (positive) results in the future and which risks are associated with an investment into it. Furthermore we need also to be able to give clear answers to how this investment will be controlled and managed. On the portfolio level it is additionally important to efficiently combine single hedge funds strategies as building blocks in portfolio with the aim to meet targeted returns and risk levels and create optimal and secure portfolio. is an integrated ongoing process which begins with defining the investment objectives and restrictions, following by hedge funds selection process containing of quantitative and qualitative analysis including a due diligence, and continuing with a portfolio construction and a risk management. It is important to underline that this is a continuous and integrated investment process based on rules and discipline, as well as creativity. Investment Objectives & Constrains Hedge Fund Selection Quantitative Analysis Qualitative Analysis Due Diligence Statistical evaluation of past performance return/volatility/correlati on/aum analysis Understanding the strategy and investment process where the alpha comes from? - Management - Investment Process - Organisation - Operation - Legal Risk Management Portfolio Construction Reality = Expectations? Correlation / Risk concentration/ Liquidity / Portfolio Risk

2 Investment Objectives & Constrains The first step of every investment process is to precisely define the investment objectives (what we want to achieve and what we do not want to achieve), as well as investment constrains (which investment restrictions do we face). Investment Objectives Investment Constrains Risk Objectives Definition of Risk Quantification of Risk Special Cases Return Objectives What is the targeted return? How is the return measured? Special Cases Liquidity Time Horizon Legal and Regulatory Factors Tax Concerns Special (individual) circumstances... Hedge Fund Selection The main goal behind the hedge fund selection process is to screen the hedge fund industry for exceptional hedge fund managers, to gain transparency about their strategies and organisations and to understand the risks associated with an investment in these managers. Generally speaking we can distinguish between: 1. Established hedge funds with an long-term track record, 2. New and promising hedge fund managers: a. with a track record from previous employer, b. without a long-term track record. All these three categories of hedge funds offer different opportunities and bear some specific risks. Therefore, the quality of information and analysis is crucial in getting transparency and judging the return/risk profile of the particular hedge fund. And beside some public information and appropriate analysis tool, it is important also to establish efficient personal network which will ensure access to some reliable information about established, as well as new and promising managers. The Hedge Fund Selection process consists of Quantitative Analysis, Qualitative Analysis and Due diligence. Quantitative Analysis In Quantitative Analysis we are filtering the hedge fund universe according to predefined parameters and focus on statistical evaluation of the past performance of the strategy over the different periods of time and different market phases. We compare, perform and evaluate: The Absolute and Relative Performance, Volatility, Correlations, Excess Kurtosis and Skewnesss, Sharp- and Sortino-ratios, Drawdown Analysis, Scenario Analysis, Assets under Management (AuM),

3 Investment Style Track record length, Experience of the fund manager etc. The aim of the Quantitative Analysis is to evaluate the historic systematic and specific risks involved with the strategy and to rank strategies/funds according to the overall return/risk profile. Qualitative Analysis The main goal of the Quantitative Analysis is to deeply understand the strategy and organisation, as well as its return and risk drivers. This is the most important and the most challenging part of the hedge fund selection process. The Qualitative Analysis consists of: 1. Compilation of dedicated investment manager and administrator questionnaires, 2. Evaluation of these questionnaires and requiring of additional information if necessary, 3. In-depth background check on the company and management, 4. Legal review. We look at and evaluate a whole list of parameters which we can divide in following groups: Company structure and organisation we need to understand how efficient and supportive the organisation and company structure is, which conflicts of interest might arise and which other weak links exist in the organisational chain. Therefore we check and analyse the whole investment team, their background and ability to perform in current operational environment, the investment processes, communication and interdependences. Additionally we prove and evaluate the financial situation of the company and the relevant fund, as well as the business/organisation stability in total. We see the organisation as the most underestimated factor in the hedge fund selection process and consider that the weakness in the organisation is the main source of most hedge fund failures. Minimum Organisational Requirements (Example) Investment Management Risk Management Support CIO Portfolio Manager CFO/COO Risk Manager Back Office IT Manager Client Support Beside the minimum organisational structure there is also a minimum threshold AuM base for different strategies and organisation which should ensure a solid operation.

4 Investment Skills we analyse the investment strategy, the generation of alpha, list and analyse instruments that are traded, leverage, style drift flexibility and the manager s degree of freedom. Every single person in the organisation must have sufficient knowledge for the position she has, and especially the hedge fund manager must have also the clear competitive advantage in her peer group. The competitive advantage should be evaluated in relation to the strategy, so that this advantage could be achieved through specific know-how, informational or even operational-trading structure. Legal Review the legal relationship between an investor and the fund is defined through the Offering Memorandum, which should be carefully reviewed. This is one of the most important legal documents but not the only one. There are also other legal documents of no less importance which should be also carefully reviewed e.g.: Articles of Association, legal documents of the Master Fund, prime brokerage/give-up/compensation agreements with prime broker etc. All documents should be compared and checked for inconsistencies. In the Legal Review we are looking for and evaluate e.g. insufficient investor s rights, contractual risks, conflicts of interest, cross-check service providers (administrator, prime broker, valuation agent etc.) etc. Due Diligence Due Diligence is a form of more detailed and more comprehensive Qualitative Analysis that includes an Onsite Visit as a crucial part. After an extensive individual preparation based on collected and analysed information we will undertake an Onsite Visit and prove the reliability and consistency of information previously gathered, identify operational weaknesses and cross-check investment processes. The adequate preparation will enable achieving two goals: being able to ask right questions and to ask many right questions in a short period of time as necessary. We want to be sure that collected and analysed information do reflect the reality and not only manager s marketing efforts, will ask hard-hitting questions, look behind the managers marketing pitch and search for discrepancies and potential misrepresentation of facts. Furthermore we want to be sure that there is also no omission of crucial information. In the Due Diligence process it is important to get a direct access to a key decision makers and not only to the investor relation department, and to personally meet all people behind the investment process and organisation, and to request to see a demonstration of these processes. Transparency and deep insights are crucial in the evaluation of information gathered in a qualitative analysis. The Onsite Visit will take place on the regular basis in order to ensure that the manger s situation has not changed and are still conformed to previous analysis. Important part of Qualitative Analysis is to quantify the results so that we can easily evaluate, compare and control them. We achieve this through giving each qualitative risk factor a ranking possibility from 1 (lowest risk) to 7 (highest risk) and consequently give each analysed factor the certain rank, so that the quality parameters can be easily tracked and incorporated into ongoing risk management process

5 Portfolio Construction Portfolio construction is based on creating a portfolio of hedge fund strategies that are complementary to each other under risk reduction premises. In other words the Portfolio Construction is the process of creating desired return/risk profile of the portfolio (return, volatility, drawdown...) through diversification of the source of profit and the source of risk. If necessary or desired we can create a risk overlay which can further minimise some risks in the portfolio. Risk Management Every hedge funds manager must have and need to explain a clear risk management process including money management rules which are going to limit unexpected negative performance or manager s ego hypotrophy. A manager should always be able to know when he is wrong and need to have the risk management mechanism already in place that is going to protect the capital. Risk Management must be adapted to the investment strategy. The risk management set of rules must be in written form and consist of daily and emergency procedures. It is essential that all rules do have an efficient implication in practice and the processes are smooth and well-organised. We examine and evaluate following common risk management rules and practices: Maximum daily, weekly, monthly, yearly losses, Maximum drawdown, Worst case scenario, Stop-loss limits, Liquidity risk limits and lock ups, Concentration limits, Ongoing stress tests, VaR Credit risk, Reliability of the computer system, Double Check procedures,

6 Organisational/Operational risks and failures, Execution failures, Pricing, reconciliation and reporting, IT and back up facilities, Active monitoring, Changes in manager strategies, Changes in risk management practices, Reviewing manager outlook, Significant changes in risk/return profile etc. On the portfolio level risk management incorporate correlation targets, derivative overlays and money management rules. As we already mentioned, the Risk Management is integrated in the whole Hedge Fund Selection process, so that all risk management parameters, rules and practices are continuously examined and evaluated in every step of the Hedge Fund Selection process. Can I control the investment? If I can control it than what is the best way to manage it? We need to have answers to all risks spotted. This does not mean that all risks should be hedged. It means that we must be aware which risks we have or could have and what we need to do in order to control them. It is not about the likelihood that certain risks while appear but to understand if and how we can control these risks. Manage what you can control! Transparency & Security through Knowledge, Discipline and Creativity! We are looking forward to doing business with you! info@treevestcapital.com THANK YOU! YOUR ASSETS SHOULD GROW! AND YOUR ASSETS SHOULD ALWAYS BE PROTECTED!