The Next Wave of Hedge Fund Investing. Today s Discussion

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1 The Next Wave of Hedge Fund Investing Adam L. Berger, CFA Vice President and Head of Portfolio Solutions AQR Capital Management, LLC December 6, 2007 Today s Discussion Hedge Funds Today Bifurcation of Investors Next Wave: The Believers Next Wave: The Skeptics Conclusions

2 Two Definitions of Hedge Funds A strategy that: Investment pools that are: Trades relatively liquid assets Seeks to make positive average returns over time Provides diversification versus traditional stock and bonds markets A Portfolio Tool Unconstrained Unregulated Charge high fees Illiquid Non-transparent Should make money all the time Run for rich people in Switzerland by rich people in CT A Compensation Structure Source: An Alternative Future 3 Estimated Growth of HF Assets Hedge Fund Industry $1,400 $1427 B $1,200 $1105 B Assets (In $Billion) $1,000 $800 $600 $400 $200 $0 $973 B $820 B $626 B $539 B $457 B $491 B $368 B $375 B $257 B $186 B $168 B $167 B $96 B $39 B $58 B Source: HFR Report

3 Are Hedge Funds Meeting Our Definition? A strategy that: Trades relatively liquid assets Side Pockets Provides diversification versus traditional stock and bonds markets Do Hedge Funds Hedge? Seeks to make positive average returns over time Source: An Alternative Future 5 Hedge Fund Returns HFRI Fund Weighted Composite Index Returns % 30% Annual Returns 20% 10% 0% -10% -20% -30% (1.5) (8.2) (10.8) (13.1) (16.7) (20.2) (22.7) HFRI Index S&P 500 MSCI World Indices: HFRI Fund Weighted Composite Index, S&P 500 Total Return Index, MSCI World Net Index 6

4 Better Opportunities for Believers HFRI Index Correlation to S&P 500 Index 5 Year Annualized Correlation to S&P Eq Non-Hedge Sector 0.75 Equity Hedge 0.75 Event Driven 0.69 Convert Bonds 0.67 Merger Arb 0.66 Emerging Mkts 0.58 Mkt Timing 0.50 Distressed 0.44 FI: High Yield Rel Value Arb Regulation D Macro Convert Arb FI: Diversified FI: Arb (0.26) Short Selling HFR Fund of Funds Composite Index HFR Fund Weighted Composite Index (0.91) Source: HFR Report Institutional Allocation to HFs Investor Challenges: Insufficient savings rates Increasing life expectancy rates Declining expected return estimates Low long-term interest rates Return Opportunities: Uncorrelated Investments Access to Alpha Providing Liquidity Sources: Merrill Lynch/CaseyQuirk s, The Brave New World: Winning Product Strategies for a Changing Global Market, September 2007; Institutional Demand for Hedge Funds 2, October

5 A Bifurcation of Investors Investors Skeptics Key Impediments: Headline Risk Lack of Transparency High Fees Believers Key Drivers: Challenge of achieving return targets Lower prospective returns to beta Benefits of diversification 9 Believers Want... More: Greater exposure to hedge funds Better: Uncorrelated returns, stronger managers Faster: Be opportunistic, provide liquidity, etc. Cheaper: Pay for alpha, pay less for hedge fund beta 10

6 More Opportunities for Believers......But where to put it? Typical Institution Asset Allocation Alternatives 6% Fixed Income 28% Other 5% Equities 61% Source: Casey Quirk and Merrill Lynch Analysis in The Brave New World: Winning Product Strategies for a Changing Global Market, September More Hedge Funds via Portable Alpha Portable Alpha combines: Systematic, market exposure (Beta) Non-correlated, active risk exposure (Alpha) Investor $100 Portable Alpha Program More efficient active management than traditional strategies $80 α Alpha Engine ($80 Investment) $20 β Index Replication ($100 Exposure) 12

7 More Hedge Funds via GTAA Global Tactical Asset Allocation Generating alpha in a capital-efficient manner by making tactical adjustments to portfolio exposures, including: Equity Country Selection Bond Country Selection Currency Selection Timing Strategies GTAA managers use futures, forwards and swaps to create overweight/underweight exposures No need to trade the underlying holdings in portfolio Strategies are subject to change. The example above is hypothetical and for illustrative purposes only. 13 Implementing GTAA $100 Investment Developed Equity Country Selection Short $44 Developed Bond Country Selection Long $34 Long $50 Stock Index Bond Futures Futures Short $54 Yield Curve Selection Long $558 2,5, & 10-Yr Interest Rate Swaps Short $549 Developed Currency Selection Long $61 Foreign Currency Forwards Short $19 Commodity Selection Long $17 Commodities Short $26 U.S. Stocks vs. U.S. Bonds vs. U.S. Cash Long $10 S&P 500 Short $21 Emerging Equity Country Selection Long $3 Index Futures Short $3 Emerging vs. Developed Timing Long $5 Index Futures Short $6 Swap Spreads Long $44 10-Yr Swap Spreads Short $44 Strategies are subject to change. The example above is hypothetical and for illustrative purposes only. 14

8 Better Hedge Fund Management Uncorrelated Risk Managed Institutional-Strength Transparent 15 Faster Hedge Fund Opportunities Liquidity Providing Capturing the liquidity premium Long-term investors Advantages Provide non-correlated sources of alpha Act as diversifier 16

9 Faster Hedge Funds: Implementation Opportunistic Investments Tactically managing a portion of capital Broad approach will allow greater flexibility Pre-commitments Analyzing beforehand Take advantage of others behavioral miscues 17 Cheaper Hedge Fund Investing Don t pay for beta Longer lockups, lower fees Hedge Fund replication 18

10 Opportunities for Skeptics Hedge fund investing without the hedge funds Alpha: Getting more alpha without hedge funds Better Beta: Adding uncorrelated return sources Clones: An alternate path to hedge fund exposures? 19 Alpha from Relaxing Constraints Relaxed Constraints ( 130/30 ) Possible Portfolio Weights for Long-Only Managers* Possible Portfolio Weights (%) Overweights Underweights Underweights Available weights Non-Available weights Index Weights In order of descending benchmark weight For Illustration Purposes Only please see important risk disclosure in Appendix A1. *Assumes 2% deviations. 20

11 Alpha from Relaxing Constraints Advantages More active risk More effective active management Maintain existing asset allocation Low transition costs Potentially lower fees relative to alpha Little or no derivatives usage Minimal leverage with clear limits 21 Better Beta Opportunities Portable Beta Approach Expected Return 7% 6% 5% 4% Risk-Free Rate Portable Beta 60/40 Portfolio Highest Sharpe Portfolio Advantage from Leverage 3% 0% 5% 10% 15% Risk (Return Volatility) For illustrative purposes only. 22

12 Better Beta from a Range of Risk Premia Equity Risk Large Cap US Equity Mid Cap US Equity Small Cap US Equity Non-US Developed Equity Emerging Equity Nominal Interest Rate Risk US Government Bonds Non-US Developed Bonds Emerging Market Debt Inflation Risk US TIPS Non-US Inflation-Link Bonds Production-Wgt Commodity Index Volatility-Wgt Commodity Index Credit/Default Risk Investment Grade Credit High-Yield Credit US Municipal Credit Global Swaps Spreads Emerging Market Currency 23 Cloning of Hedge Fund Strategies HF Replication Strategies may offer: Transparency Liquidity Capacity Lower Fees But may not solve the problems of: Leverage Derivatives Shorting Event Risk Correlation 24

13 Cloning Strategies: Implementation Hedge Replication Still in its infancy, but there are two main approaches: 1. Factor Replication: Seeks to replicate hedge fund returns through exposure to elementary risks such as equities, currencies, interest rates May give you the part of hedge fund returns you don't want 2. Trade Replication: Seeks to "do what hedge funds do" through a mechanical, rules-based investment approach May be too much like a hedge fund to appease the skeptics Replication will be important to watch as it develops Conclusion: The Big Question Are you a skeptic or a believer? Why Your Answer Matters: Setting Investment Policy Portfolio Governance Choosing Strategies Selecting Managers Staffing Risk Management 26

14 Action Steps for Investors Are you a skeptic or a believer? Solutions for Believers: Portable Alpha Tactical Asset Allocation Opportunistic Solutions for Skeptics: 130/30 Global Beta Funds Hedge Fund Replication 27 How Many Re-Inventions? Does the industry keep re-inventing itself? Or are these the same questions we asked three years ago? Do believers and skeptics want different things, or are they in different places on a continuum? 28

15 Contact Information Adam L. Berger, CFA Vice President and Head of Portfolio Solutions AQR Capital Management, LLC Tel Fax A1. Disclosures PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. All performance figures contained herein represent estimates prepared by AQR Capital Management, LLC. There is no guarantee as to the above information's accuracy or completeness. There is a risk of substantial loss associated with trading commodities, futures, options and leverage. Before investing carefully consider your financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when engaging in leverage, trading futures, commodities and/or granting/writing options one could lose the full balance of their account. It is also possible to lose more than the initial deposit when engaging in leverage, trading futures and/or granting/writing options. All funds committed should be purely risk capital. 30

16 A1. Performance Disclosures AQR Capital Management, LLC Global Risk Premium Composite 1/1/06 6/30/07 Year Total Return Gross of Fees % Total Return Net of Fees % Benchmark* Return % Number of Portfolios Dispersion % Composite Assets End of Period ($ M) Total Firm Assets ($ M) % of Firm Assets N/A , /30/ N/A , * Merrill Lynch 3 Month Treasury Bill Index AQR Capital Management, LLC ( AQR ) has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS ). This presentation cannot be used in a general solicitation or general advertising to offer or sell interest in its Funds. As such, this information cannot be included in any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and cannot be used in any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. Notes: Firm Information: AQR is a Connecticut based investment advisor registered with the Securities and Exchange Commission under the Investment Advisors Act of AQR conducts trading and investment activities, specializing in global asset allocation and global stock selection involving a broad range of instruments, including, but not limited to, individual equity and debt securities, currencies, futures, commodities, fixed income products and other derivative securities. For purposes of Firm wide compliance and Firm wide total assets, AQR defines the Firm as entities controlled by AQR that are registered as investment advisors with the Securities and Exchange Commission. The Firm is comprised of AQR and CNH Partners, LLC ( CNH ). Upon request AQR will make available a complete list and description of all of Firm composites. Past performance is not an indication of future performance. 31 A1. Performance Disclosures Fees: AQR s asset based fees for portfolios within the composite may range up to 1% of assets under management, and are generally billed monthly or quarterly at the commencement of the calendar month or quarter during which AQR will perform the services to which the fees relate, and are negotiable for some accounts in certain circumstances. In addition, AQR funds incur administrative fees and may have a redemption charge of 2% based on gross redemption proceeds may be charged upon early withdrawals. Please refer to the Fund s Private Offering Memoranda and AQR s ADV Part II, Schedule F for more information on fees. Composite Characteristics: The Global Risk Premium composite (the Composite ) was created in January The accounts included invest all their assets in the AQR Global Risk Premium Master Account Ltd. ( Master Account ). The composite benchmark is the Merrill Lynch 3 Month Treasury Bill Index. The Composite is comprised solely of the Master Account. The investing feeders of the Master Account are not considered because they are one hundred percent invested in the said Master Account. The investments in the Composite vary substantially from those in the Benchmark. AQR generally uses stock index futures and FX forwards in the Composite accounts to equitize a portfolio, take country tilts and manage FX exposure. Consequently, an adverse change in the relevant price level can result in a loss of capital that is more exaggerated than would have resulted from an investment that did not involve the use of leverage inherent in the derivative contract. Many of the derivative contracts used by the Master Account are privately negotiated in the over-the-counter market. These contracts also involve exposure to credit risk since contract performance depends in part on the financial condition of the counter-party. These transactions are also expected to involve significant transaction costs. The risks inherent to the strategies employed by the Master Account are set forth in the applicable offering documents and other information provided to potential subscribers. Calculation Methodology: Valuations and returns are computed and stated in U.S. dollars, and individual portfolios are revalued monthly. The firm uses the Modified Dietz formula to calculate monthly returns and links these returns geometrically to produce an accurate time-weighted rate of return. Composite returns are asset-weighted. Gross of fees returns are calculated gross of management, administrative and custodial fees and net of transaction costs. Returns are calculated net of all withholding taxes on foreign dividends. Accruals for fixed income and equity securities are included in calculations. Net of fees returns assume net of management fees of 1%. Dispersion is not considered meaningful for periods shorter than one year or for periods during which the composite contains fewer than five accounts for the full period. Additional information regarding policies for calculating and reporting returns is available upon request. Other Disclosures: AQR has been verified for the periods from 1/1/1998 to 3/31/2006 by Beacon Verification Services. A copy of the verification report is available upon request. 32