September 23, 2015 Hedge Fund Strategy Education Water & Power Employees Retirement Plan
Introduction
Introduction The Asset/Liability Study highlighted opportunities that may help the Plan achieve its long-term objectives with reduced volatility. One of these includes increasing the allocation to hedge funds. Currently, the Plan has a 1.8% target allocation to hedge funds. The allocation is split equally between two complementing strategies managed by Morgan Stanley and GAM. These are fund-of-funds, not direct investments in hedge funds. This presentation is the first piece of several discussions designed to help familiarize the Board with hedge funds. This presentation will focus on hedge funds in general, including strategies and methods for accessing them. We will follow this with an asset allocation study that looks more precisely at the impacts of increasing the Plan s allocation to hedge funds. This will be followed with additional education materials focused more directly on the mandate types we would be looking to fill the increased allocation. RVK 3
Introduction to Alpha Strategies
Overview of Alpha-Oriented Strategies Alpha: Investments intended to provide diversification (primarily with the Capital Appreciation and Capital Preservation components), which is obtained via investments that: Rely on manager skill rather than specific asset class exposures: Rotating market exposures based on valuations Navigating less liquid markets and special situations Predicting and capturing market trends Allow for flexibility of tools and allocations: Leverage Short-selling Derivatives Multiple asset classes and regions RVK 5
Overview of Alpha-Oriented Strategies Methods for Gaining Alpha Exposure Direct Hedge Fund Direct investment in one or more individual hedge funds Diversified Hedge Funds (DHF) A fund consisting of a portfolio of underlying hedge funds GTAA Tactical exposure across multiple asset classes Considerations Reduced program cost vs. DHFs Ability to customize portfolio exposures Higher level of headline risk Need for larger allocations to achieve manager diversification Considerations Outsourced manager due diligence Well-diversified portfolio in a single investment Higher fees (additional fee typically 1% + 10% of profits above return hurdle) Considerations Liquidity Tactical exposure management Lower fees (median fee of peer universe is 90bps). Reduced access to certain hedge fund strategies (e.g., distressed debt) RVK 6
Overview of Alpha-Oriented Strategies Alpha investments are similar in their overall goals but may differ substantially in their approaches to generating returns. Liquidity preferences as well as client objectives and constraints should inform how the Alpha portfolio is constructed. Varying Sources of Return Generation Bottom-Up Alpha Top-Down Alpha Illiquidity Premium Direct Hedge Funds High Medium High Diversified Hedge Funds High Low-Medium High GTAA Medium High Low Bottom-Up: An investment approach that de-emphasizes the significance of economic and market cycles. This approach focuses on the analysis of individual holdings. Illiquidity Premium: A premium that investors demand when a security can not be easily converted into cash, and converted at the fair market value. Top-Down: An investment approach that involves looking at the "big picture" in the economy and financial world and then breaking those components down into finer details. RVK 7
Diversified Hedge Fund ( DHF ) Strategy Basics
DHF Overview: What are Hedge Funds? A diverse industry, not easily painted with one brush stroke Much like asking What is a mutual fund? Private partnerships that apply focused skill-based strategies Strategy, risk, and return profiles vary, but funds can be classified into the following broad categories: Directional: Investment in positions designed to gain from advances or declines in equity or bond markets Non-Directional: Managers attempt to identify profitable arbitrage opportunities among related securities (relative value) Arbitrage: Seeks to profit from pricing anomalies between a company s convertible securities and its equity. A manager buys the convertible instrument (often a bond) and sells short the common stock. RVK 9
DHF Overview: What are Hedge Funds? Differentiators vs. Traditional Asset Classes Less Directional Focus on adding alpha through long and short positions Not managed to a specific benchmark Returns will differ from traditional markets Often exhibit lower correlation and beta to traditional asset classes Less Liquid Strategies range in terms of liquidity Funds that emphasize more liquid assets (equities) may have monthly or quarterly redemption windows Funds that focus on less liquid opportunities (distressed credit) can have multiple year lock-ups Use of Leverage Magnitude varies depending on the manager and strategy Distressed credit managers often use little or no leverage Relative Value/Arbitrage managers utilize higher levels of leverage Other Differentiators: Regulation: 2010 financial reform required most hedge funds to register with the SEC. Previously, exemptions encouraged many firms not to register. Fees: Managers generally charge management and performance based fees (2% & 20%), with additional fees at the DHF level (1% & 10%). Structure: Typically private partnerships, available only to qualified investors. Short Positions: Short selling involves selling a borrowed security on the belief that it will decline, and buying it back at a later date for a lower price. Beta: A measure of the sensitivity of a portfolio to the movements in the market. It is a measure of a portfolio's non-diversifiable or systematic risk. Leverage: The use of financial instruments or borrowed capital to increase the potential return of an investment. RVK 10
DHF Overview: Unique Risks Like any investment, hedge fund strategies are subject to a variety of risks. These are less constrained strategies, so there are additional risks to consider. Failures can occur due to operational risks, investment risks, or fraud. A thorough due diligence process is needed to mitigate these risks. Operational Risks Investment Risks Other Risks Critical, non-investment attributes to review: Service Providers Transparency Valuation Quality and Depth of Back-Office Counterparty Risk Control Risk Unique risks beyond those found in actively-managed long-only strategies: Complexity Leverage Liquidity Concentration Risk of Strategy Failure Headline Fraud Regulatory RVK 11
DHF Strategy Characteristics
DHF Strategy Characteristics Risk/Return Profiles Directional Higher Volatility Global Macro Short Selling Emerging Markets Expected Return Non-Directional Lower Volatility Moderate Volatility Convertible Arbitrage Fixed Income/Credit Arbitrage Equity Market Neutral Long/Short Equity & Credit Risk/Merger Arbitrage Distressed Securities Expected Volatility Hedge funds can be classified into the following broad categories: Directional: Investment in positions (both long and short) designed to gain from advances or declines in equity or bond markets Non-Directional: An attempt to identify arbitrage opportunities (relative value) in mispricings of related securities, market direction Event-Driven: Trading in securities that are (or may become) involved in mergers, bankruptcy, or other corporate events RVK 13
DHF Strategy Characteristics Directional Strategies Long/Short Equity: Core holding of long equities hedged to varying degrees with short positions in stocks or derivatives. Global Macro: Employs a top down approach to invest across a wide range of global asset classes based on forecasted changes in global economies, political fortunes, or global supply and demand for resources Short Selling: Taking short positions in stocks in anticipation of a price decline, based on a view that the stock is overvalued, company earnings will disappoint, or there is a market selloff approaching Emerging Markets: Generally long-biased equity or debt positions that seek to capitalize on the undervaluation of companies in developing countries, which tend to have higher inflation and volatile growth HFN: HedgeFund.net RVK 14
DHF Strategy Characteristics Non-Directional Strategies Convertible Arbitrage: Seeks to profit from pricing anomalies between a company s convertible securities and its equity. A manager buys the convertible instrument (often a bond) and sells short the common stock. Fixed Income/Credit Arbitrage: Exploits pricing inefficiencies between fixed income securities with similar characteristics, such as corporate vs. Treasury yield spreads. Offsetting long and short positions typically neutralize exposure to interest rate risk, isolating the pricing discrepancy. Equity Market Neutral: Exploits relative pricing inefficiencies between equity securities while neutralizing market exposure. Typically the net (total long and short) portfolio exposure is balanced so that there is no directional bias to equity sectors or styles. HFN: HedgeFund.net RVK 15
DHF Strategy Characteristics Event-Driven Strategies Risk/Merger Arbitrage: Invests in the shares of companies involved in mergers, acquisitions, and LBOs. A common merger arbitrage strategy is to buy the equity of the target and sell short the equity of the acquirer, making a profit if the deal outcome (and timing) is in line with the manager s positioning. Distressed Securities (HFN Distressed Index): Managers pursuing this strategy invest in bank debt, corporate debt, trade claims, common stock, and warrants of companies either in bankruptcy or having financial or operational issues. The goal is to anticipate how corporate events (such as bankruptcies, reorganizations, distressed sales, and restructurings to reverse negative trends) will impact the underlying securities. HFN: HedgeFund.net RVK 16
DHF Strategy Characteristics Broad Hedge Fund Categories Equity Strategies Managers invest in positions (both long and short) designed to gain from advances or declines in equity markets Credit Strategies Managers invest long and short in credit securities and sectors. Most managers use extensive fundamental analysis in security selection Market Neutral Strategies Managers seek to identify mispricing of related financial instruments and hedge out undesired market exposures Global Macro Strategies Systematic, momentum, and discretionary strategies that seek to generate alpha via top-down decision making and models RVK 17
DHF Strategy Characteristics Equity Strategies Equity hedge funds seek to generate returns by taking long and short positions in their chosen markets and sectors. Fund exposures range from dedicated short to long-biased. Long/Short: Funds may invest in a portfolio of long equities and hedge market exposure via short positions in industry or index futures. Managers are generally 30-70% net long. Activist: Investor takes a sizeable stake in a company and seek to unlock shareholder value by working closely with the company s Board of Directors and/or upper management. Short Bias: Managers focus on companies or sectors they believe will face headwinds going forward. Key Market Risks: Depending on the manager, strategies can be highly concentrated and at times have significant directional market risk (equity beta). Equity Beta: The sensitivity of a strategy to price movements in the broad equity markets. RVK 18
DHF Strategy Characteristics Credit Strategies Credit hedge funds seek to achieve returns through the fundamental analysis of individual corporate credits or pools of structured securities. Long/Short: Funds may invest in bonds of individual companies on a fundamental basis and hedge risk via index futures. Credit Arbitrage: Manager may identify mispricing of credits of similar quality and take a long and short position until pricing converges to fair value. Managers may also use single name CDS to hedge company risk. Distressed: Manager invests in less liquid debt of a company or pool of capital in financial distress (e.g., post bankruptcy). Securities are purchased at steep discounts to par and held through the reorganization process. Key Market Risks: Most strategies have some sensitivity to credit spreads, but managers must also be aware of basis risk and liquidity. Structured Credit Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Backed Securities (CMBS), Collateralized Loan Obligations (CLOs), etc. RVK 19
DHF Strategy Characteristics Market Neutral Strategies Managers take long and short positions in related financial instruments that appear mispriced relative to one another. Market risk is removed through dollar neutrality for every dollar invested long another is invested short. Strategies can be implemented via equity pairs, fixed income spreads, etc. Market Neutral Equity: Managers use qualitative and quantitative analysis to focus on mispricings between two companies (or a company relative to its broad industry) with divergent prospects. Relative Value: A catch-all description, relative value managers seek to profit from mispriced securities across markets and capital structures, including equity pairs, sovereign debt market curve structures, foreign currency pairs, etc. Key Market Risks: Basis risk (imperfect hedging) and leverage. RVK 20
DHF Strategy Characteristics Global Macro Strategies Macro hedge funds can be long or short assets across global markets and often implement top-down views via futures or options. Discretionary: Focus is on predicting the impact that changes in the global economy have on asset prices. Managers generally have views on government policies across the globe and their associated effects on rates, currencies, equity prices, and commodities. Systematic: Strategy focuses on historical relationships between asset prices and seeks to take advantage when those relationships break down. Models can be driven by fundamental and technical factors. Trend Following: Generally systematic strategies that seek to capture trends in price momentum. Implementation through futures and options. Key Market Risks: Market risks are not consistent across strategies as positioning varies. Leverage and investor skill determine risks. RVK 21
DHF Strategy Characteristics Diversified Hedge Funds DHFs incorporate many of the previously outlined strategies. Investment team actively manages portfolio to ensure diversification and risk oversight. Managers seek to identify top-tier managers and allocate capital to the best strategies given expected market conditions. Funds typically target absolute returns in the range of Treasury-Bills + 4-6%. DHFs had difficult years in 2008 and 2011, but have since generated returns more in line with investor expectations. RVK 22
2015 RVK Asset Allocation Assumptions DHF has produced attractive correlations and risk-adjusted returns over the long term RVK Assumptions vs. Longest Historical Time Frame Asset Class Arithmetic Return Assumption Standard Deviation Assumption *Custom Non-Core Real Estate Index = April 1, 2013 to Present is NCREIF-CEVA Index; prior to April 1, 2013 was 70% NCREIF Townsend Value Added + 30% NCREIF Townsend Opportunistic *Custom Diversified Inflation Strategies Index = 1/3 Barclays US TIPS + 1/3 Bloomberg Commodity + 1/3 MSCI Global Real Estate (Gross) RVK 23 Index Longest Historical Time Frame Annualized Arithmetic Return Annualized Standard Deviation Large/Mid Cap US Equity 7.00% 17.75% S&P 500 (Cap Wtd) Jan 1926 - Dec 2014 11.45% 18.90% Small Cap US Equity 7.50% 21.25% Russell 2000 Jan 1979 - Dec 2014 13.25% 19.64% Dev'd Large/Mid Int'l Equity 8.00% 19.00% MSCI EAFE (Gross) Jan 1970 - Dec 2014 10.74% 17.08% Dev'd Small Int'l Equity 8.50% 23.00% MSCI EAFE Small Cap (Gross) Jan 1999 - Dec 2014 9.77% 18.53% Emerging Markets Equity 10.50% 29.00% MSCI Emg Mkts (Gross) Jan 1988 - Dec 2014 13.79% 23.38% Int. Duration Fixed Income 3.50% 6.00% Barclays US Agg Bond Jan 1976 - Dec 2014 7.74% 5.46% High Yield Fixed Income 6.00% 15.00% Barclays US Corp: Hi Yld Jul 1983 - Dec 2014 9.24% 8.49% Diversified Infl Strat 5.65% 11.45% Custom Div Infl Strat Index* Mar 1997 - Dec 2014 5.44% 11.26% Core Real Estate 6.75% 12.50% NCREIF ODCE (Gross) (AWA) Jan 1978 - Dec 2014 (Q) 8.47% 5.46% Non-Core Real Estate 9.75% 22.50% Custom Non-Core RE Index* Apr 1989 - Sep 2014 (Q) 7.82% 9.21% Diversified Hedge Funds 6.50% 9.50% HFN FOF Multi-Strat (Net) Jan 1982 - Dec 2014 11.19% 5.65% Private Equity 10.50% 26.00% Cambridge US Private Equity Index Apr 1986 - Jun 2014 (Q) 13.65% 9.63% Statistics are calcualted based on monthly periodicity, except where noted by (Q) for quarterly periodicity. RVK Correlation Assumptions Large/Mid Cap US Equity Small Cap US Equity Dev'd Large/Mid Int'l Equity Dev'd Small Int'l Equity Emerging Markets Equity Int. Duration Fixed Income High Yield Fixed Income Diversified Infl Strat Core Real Estate Non-Core Real Estate Diversified Hedge Funds Large/Mid Cap US Equity 1.00 0.84 0.83 0.76 0.74 0.15 0.60 0.61 0.22 0.19 0.50 0.73 Small Cap US Equity 0.84 1.00 0.75 0.74 0.72 0.07 0.62 0.58 0.18 0.13 0.51 0.69 Dev'd Large/Mid Int'l Equity 0.83 0.75 1.00 0.92 0.81-0.01 0.66 0.73 0.31 0.19 0.65 0.74 Dev'd Small Int'l Equity 0.76 0.74 0.92 1.00 0.85 0.05 0.70 0.77 0.35 0.21 0.72 0.69 Emerging Markets Equity 0.74 0.72 0.81 0.85 1.00-0.02 0.65 0.74 0.23 0.13 0.67 0.66 Int. Duration Fixed Income 0.15 0.07-0.01 0.05-0.02 1.00 0.26 0.20-0.08-0.06 0.08-0.24 High Yield Fixed Income 0.60 0.62 0.66 0.70 0.65 0.26 1.00 0.61 0.11 0.07 0.41 0.51 Diversified Infl Strat 0.61 0.58 0.73 0.77 0.74 0.20 0.61 1.00 0.37 0.21 0.59 0.62 Core Real Estate 0.22 0.18 0.31 0.35 0.23-0.08 0.11 0.37 1.00 0.87 0.25 0.60 Non-Core Real Estate 0.19 0.13 0.19 0.21 0.13-0.06 0.07 0.21 0.87 1.00 0.21 0.53 Diversified Hedge Funds 0.50 0.51 0.65 0.72 0.67 0.08 0.41 0.59 0.25 0.21 1.00 0.68 Private Equity 0.73 0.69 0.74 0.69 0.66-0.24 0.51 0.62 0.60 0.53 0.68 1.00 Private Equity
DHF Strategy Characteristics As of June 30, 2015 Firm/Product HFN Long/Short Equity HFN Distressed HFN Event Driven HFN Relative Value HFN Macro HFN FoHF Multi-Strategy HFN Multi-Strategy Index S&P 500 Index Barclays US Agg BofA ML 3 Month T-Bill Index + 5% 60% ACWI/40% BGbl AGG Annualized Returns (Net of Fees) Current Quarter YTD 1 Year 3 Year 5 Year 7 Year 1.4 4.9 5.1 9.8 7.2 4.8 6.3-0.5 0.2-6.0 8.0 7.3 5.5 6.1 1.2 5.0 2.5 9.2 7.0 6.4 6.6 0.0 2.4 2.1 5.9 5.2 4.5 5.6-2.0 2.1 3.7 2.9 2.7 2.9 5.1 0.1 2.6 3.4 6.1 4.0 0.9 2.9-0.4 2.2 2.6 6.3 4.7 2.9 4.8 0.3 1.2 7.4 17.3 17.3 9.4 7.9-1.7-0.1 1.9 1.8 3.3 4.6 4.4 1.2 2.5 5.0 5.1 5.1 5.2 6.5 10 Year -0.3 0.4-2.4 7.4 8.1 4.2 5.5 RVK 24
DHF Strategy Characteristics As of June 30, 2015 Benchmark: S&P 500 Index 125 Ten Year Up/Down Market Capture Ratio 10 Ten Year Risk/Return Up Mkt Capture Ratio, % 100 75 50 25 0 0 25 50 75 100 125 Down Mkt Capture Ratio, % Total Annualized Return, % 8 6 4 2 0 2 4 6 8 10 12 14 16 Total Annualized StdDev, % Up M k t Cap Ratio, % Up Mkt Months Dow n M k t Cap Ratio, % Dow n Mkt Months HFN Long/Short Equity 50.23 79 42.25 41 HFN Distressed 43.01 79 32.60 41 HFN Event Driven 44.57 79 31.66 41 HFN Relative Value 31.06 79 16.71 41 HFN Macro 23.41 79 7.33 41 HFN FoHF Multi-Strategy 27.09 79 26.94 41 HFN Multi-Strategy Index 33.73 79 25.67 41 60% ACWI/40% BGbl AGG 64.76 79 67.43 41 S&P 500 Index 100.00 79 100.00 41 Annualized Re turn Annualized Std. Dev. Sharpe Ratio HFN Long/Short Equity 6.29 7.50 0.66 HFN Distressed 6.08 7.34 0.65 HFN Event Driven 6.63 6.50 0.81 HFN Relative Value 5.59 4.33 0.96 HFN Macro 5.08 4.05 0.90 HFN FoHF Multi-Strategy 2.94 5.29 0.31 HFN Multi-Strategy Index 4.84 5.08 0.68 60% ACWI/40% BGbl AGG 5.55 11.12 0.42 S&P 500 Index 7.89 14.74 0.50 RVK 25
DHF Strategy Characteristics As of June 30, 2015 Rolling 3-Year Annualized Returns 25 20 Total Annualized Return, % 15 10 5 0-5 -10-15 Dec 01 Dec 03 Dec 05 Dec 07 Dec 09 Dec 11 Dec 13 Jun 15 HFN Long/Short Equity HFN Distressed HFN Event Driven HFN Relative Value HFN Macro HFN FoHF Multi-Strategy HFN Multi-Strategy Index S&P 500 Index Barclays US Agg RVK 26
DHF Strategy Characteristics As of June 30, 2015 MPT Stats vs. S&P 500 Index 10-Year MPT Statistics Firm/Product Return Standard Sharpe Best Monthly Worst Monthly # of Up Market # of Down Max Deviation Ratio Return, % Return, % Months Market Months Drawdown HFN Long/Short Equity 6.3 7.5 0.6 5.5-7.0 79.0 41.0-23.9 HFN Distressed 6.1 7.3 0.6 5.6-11.2 82.0 38.0-29.9 HFN Event Driven 6.6 6.5 0.8 5.2-6.3 81.0 39.0-22.0 HFN Relative Value 5.6 4.3 1.0 3.8-6.0 90.0 30.0-14.9 HFN Macro 5.1 4.1 0.9 3.8-1.9 74.0 46.0-6.7 HFN FoHF Multi-Strategy 2.9 5.3 0.3 3.1-6.6 77.0 43.0-21.1 HFN Multi-Strategy Index 4.8 5.1 0.7 3.9-6.0 80.0 40.0-18.6 S&P 500 Index 7.9 14.7 0.4 10.9-16.8 79.0 41.0-50.9 Barclays US Agg 4.4 3.3 0.9 3.7-2.4 80.0 40.0-3.8 60% ACWI/40% BGbl AGG 5.5 11.1 0.4 7.4-13.4 73.0 47.0-37.1 Firm/Product Alpha Beta R-Squared Up Market Up Market Down Market Down Market Capture Return Capture Return HFN Long/Short Equity 2.1 0.4 70.1 50.2 13.4 42.2-6.2 HFN Distressed 2.2 0.4 55.8 43.0 11.4 32.6-4.8 HFN Event Driven 2.9 0.4 63.1 44.6 11.9 31.7-4.7 HFN Relative Value 2.7 0.2 59.7 31.1 8.3 16.7-2.5 HFN Macro 2.8 0.1 25.4 23.4 6.2 7.3-1.1 HFN FoHF Multi-Strategy -0.1 0.2 48.2 27.1 7.2 26.9-4.0 HFN Multi-Strategy Index 1.6 0.3 63.9 33.7 9.0 25.7-3.8 Barclays US Agg 2.9 0.0 0.3 10.0 2.7-11.7 1.7 60% ACWI/40% BGbl AGG -0.3 0.7 84.4 64.8 17.2 67.4-10.0 MPT Stats vs. Barclays US Agg Firm/Product Alpha Beta R-Squared Up Market Up Market Down Market Down Market Capture Return Capture Return HFN Long/Short Equity 5.0-0.1 0.1 68.7 4.9-52.5 1.3 HFN Distressed 4.8 0.0 0.0 67.4 4.8-47.9 1.2 HFN Event Driven 5.4-0.1 0.1 72.5 5.2-54.7 1.4 HFN Relative Value 3.7 0.2 1.6 65.8 4.7-33.9 0.9 HFN Macro 3.1 0.2 2.6 59.9 4.3-30.5 0.8 HFN FoHF Multi-Strategy 1.5 0.0 0.0 36.1 2.6-14.1 0.4 HFN Multi-Strategy Index 3.2 0.1 0.3 59.1 4.2-23.8 0.6 S&P 500 Index 5.7 0.2 0.3 127.5 9.1 43.8-1.1 60% ACWI/40% BGbl AGG 1.7 0.8 5.7 126.8 9.1 127.5-3.2 RVK 27
DHF Strategy Characteristics As of June 30, 2015 15 10-Year Distribution of Monthly Returns 0 15 0 15 0 15 Frequency 0 15 0 15 0 15 0 15 0 15 0-17.00-13.75-11.50-9.25-7.00-4.75-2.50-0.25 2.00 4.25 6.50 8.75 11.00 Monthly Returns HFN Long/Short Equity HFN Distressed HFN Event Driven HFN Relative Value HFN Macro HFN FoHF Multi-Strategy HFN Multi-Strategy Index S&P 500 Index Barclays US Agg RVK 28
Performance Characteristics Annual Index Performance 40.0% Fund of Hedge Funds Returns vs. S&P 500 Index & Barclays US Agg Bond Index Annual Returns Since 1990 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD 2015 S&P 500 Index (Cap Wtd) Barclays US Agg Bond Index HFN FOF Multi-Strat Index (Net) Note: The HedgeFund.net Index (HFN) Fund of Funds Multi-Strategy is an equally weighted performance summary of fund of hedge fund managers. 2015 YTD performance is as of July 31, 2015. RVK 29
Diversified Hedge Funds Return Distribution Analysis & Up/Down Capture DHF has performed well in both equity up and down markets Monthly Average Return 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% Versus the S&P 500 Index (1990 July 31, 2015) S&P 500 Index (Cap Wtd) 3.3% S&P 500 Index (Cap Wtd) Barclays US Agg Bond Index 0.6% During S&P 500 Up Months Barclays US Agg Bond Index HFN FOF Multi-Strat Index (Net) 1.1% HFN FOF Multi-Strat Index (Net) S&P 500 Index (Cap Wtd) -3.5% S&P 500 Index (Cap Wtd) Barclays US Agg Bond Index 0.4% During S&P 500 Down Months Barclays US Agg Bond Index HFN FOF Multi-Strat Index (Net) -0.1% HFN FOF Multi-Strat Index (Net) % of Months > 0 100% 74% 85% 0% 63% 52% % of Months < 0 0% 26% 15% 100% 37% 48% # of Months > 0 198 146 169 0 69 57 # of Months < 0 0 52 29 109 40 52 RVK 30
Implementation Options
DHF Overview: Implementation Options Diversified Hedge Funds (DHFs) Approach A manager creates a portfolio of hedge funds, resulting in a single, diversified investment vehicle for a number of investors (commingled fund vehicle). Direct Investment Approach A consultant works with a client to create a diversified portfolio of hedge funds. Level of client discretion in fund selection decisions and portfolio structure varies by advisor and client. RVK 32
Implementation Options Diversified Hedge Fund Approach Advantages: One investment provides instant diversification Manager has ability to make tactical allocations to various strategies Outsourced manager search, selection, due diligence, risk management, and reporting Reduced headline or blow-up risk through a diverse manager lineup Possibility of improved access to top-tier hedge fund managers closed to other investors One relationship, one set of documents, one redemption schedule Better liquidity than a newly-constructed direct HF portfolio Disadvantages: Charge an extra layer of fees on top of underlying hedge fund fees Possibly too much diversification Research shows that benefits can wane beyond 15-20 managers No control over strategy and manager selection Typically little or no contact with underlying managers Ability to be nimble in rebalancing may be impaired due to lock-up periods Less transparency: investors typically receive risk-level transparency (geographic/strategy exposures, gross/net exposures, etc.) but may not have visibility of all underlying hedge funds RVK 33
Generic FoHF vs. Core/Satellite Sample Portfolio Structures RVK recommends diversified marketable alternatives portfolios that vary in structure based on the size, objectives, and constraints of each client. Each structure is capable of providing an attractive risk/return profile. Absent liquidity constraints, RVK recommends that some component of the marketable alternatives allocation be in hedge funds. DHF Only DHF Core DHF Core/Satellite Long/Short Equity 2 DHFs Direct Multi- Strategy Niche DHFs DHFs Long/Short Equity 1 Direct Multi- Strategy DHFs Niche DHFs RVK 34