The Pros and Cons of Hedge Funds

The Pros and Cons of Hedge Funds Sharon M. Goodman Principal Slevin & Hart, P.C. Washington, D.C. Michael D. Joyce, Esq., CEBS Executive Vice President and Senior Consultant The Marco Consulting Group Boston, Massachusetts Edward D. Patchett, CFA Director, Business Development GCM Grosvenor Chicago, Illinois The opinions expressed in this presentation are those of the speaker. The International Foundation disclaims responsibility for views expressed and statements made by the program speakers. I09-1

Hedge Funds Three Perspectives Reintroduction to hedge funds and fund of funds strategies Why do investors use hedge funds An investment consultant s perspective Hedge fund risks, returns and expectations An investment manager s perspective Ways to protect your plan A plan counsel s perspective After recent performance struggles, what does the future hold for hedge fund strategies and investors sentiment? I09-2

What Are Hedge Funds? Privately-offered investment vehicles not constrained by a specific benchmark Use traditional and alternative asset classes Use specialized trading strategies More tools available Attempt to take advantage of market inefficiencies Use an expanded set of financial instruments and securities Can use leverage Generally have less exposure to market risk I09-3

4 Hedge Fund Strategies DIRECTIONAL LOWER HIGHER Target Return % RELATIVE VALUE Convertible Arbitrage Fixed Income Arbitrage Equity Market Neutral EVENT DRIVEN Merger Arbitrage Special Situations Distressed Securities Global Macro Long Biased Short Sellers Expected Risk % LOWER HIGHER I09-4

Why Plans Initially Got Involved Diversification / Low Correlation HFOFs and hedge funds generally offer differentiated risk/return profiles relative to traditional bond and equity investments HFOFs and hedge fund strategies offer a variety of correlation benefits Preservation of Capital / Downside Protection HFOFs and hedge funds have consistently preserved capital during more stressed market environments Reduced Equity Volatility HFOFs and hedge funds use a variety of investment tools to mitigate equity risk in order to deliver steady returns with lower volatility Long-term, HFOFs and hedge funds have outperformed unhedged investments on a risk-adjusted basis Diversification / Investment Flexibility HFOFs and hedge funds offer flexible investment mandates, enabling them to adapt to changing market environments and to capitalize on the prevailing opportunity set I09-5

Why Plans Initially Got Involved Diversification / Correlation Benefits Correlation Analysis: January 1994 - April 2016 HFRI FOF Composite S&P 500 S&P 400 Index (Mid Cap) S&P 600 Index (Small Cap) MSCI ACWI Barclays U.S Aggregate Bond Barclays HY Credit Bloomberg Commodity Index S&P 500 0.607 S&P 400 Index (Mid Cap) 0.656 0.900 S&P 600 Index (Small Cap) 0.621 0.792 0.914 MSCI ACWI 0.684 0.944 0.881 0.789 Barclays U.S Aggregate Bond 0.038 0.035 0.007-0.072 0.019 Barclays HY Credit 0.546 0.625 0.649 0.613 0.678 0.217 Bloomberg Commodity Index 0.445 0.317 0.374 0.328 0.428 0.045 0.359 CS Leveraged Loan Index 0.474 0.428 0.481 0.444 0.488-0.022 0.756 0.368 I09-6

Why Plans Initially Got Involved Downside Protection Up/Down Market Analysis Average monthly net returns January 1990 August 2016 3.24% HFRI FW Composite S&P 500 Index 1.70% 0.82% 0.84% 0.79% 3.51% Down Market Up Market All Markets 114 months 206 months 320 months Data sources: Hedge Fund Research (HFR); S&P. S&P and its third party information providers do not accept liability for the information and the context from which it is drawn. Past performance is not necessarily indicative of future results. I09-7

Why Plans Initially Got Involved Positive Slope to Hedge Fund Returns Count of monthly returns by range January 1990 August 2016 66 75 HFRI FW Composite 66 38 instances of extreme negative monthly returns for equities; 3 instances for hedge funds 47 44 49 S&P 500 38 27 30 35 33 28 25 16 16 19 3 4 11 8 < 4% 4% to 3% 3% to 2% 2% to 1% 1% to 0% 0% to 1% 1% to 2% 2% to 3% 3% to 4% > 4% Extreme negative Strong negative Modest negative Modest positive Strong positive Extreme positive Data sources: Hedge Fund Research (HFR); S&P. S&P and its third party information providers do not accept liability for the information and the context from which it is drawn. Past performance is not necessarily indicative of future results. I09-8

Why Plans Initially Got Involved Downside Protection Hedge Funds During Challenging Environments Ten worst monthly S&P 500 drawdowns January 1990 August 2016 HFRI FW Composite S&P 500 Index 16.8% 14.5% 10.9% 10.6% 8.7% 9.1% 9.0% 8.9% 8.4% 8.4% 8.1% 6.8% 6.1% 3.5% 2.2% 2.8% 1.5% 1.2% 1.3% 0.1% Oct 08 Aug 98 Sep 02 Feb 09 Feb 01 Aug 90 Sep 08 Jun 08 Jan 09 Sep 01 Data sources: Hedge Fund Research (HFR); S&P. S&P and its third party information providers do not accept liability for the information and the context from which it is drawn. Past performance is not necessarily indicative of future results. I09-9

Why Plans Initially Got Involved Higher Cumulative Return, Lower Volatility $14,000 $12,000 $10,000 $8,000 Growth of $1,000 vs. market indices January 1990 August 2016 Annualized Return Volatility HFRI FW Composite 10.0% 6.7% S&P 500 9.4% 14.5% Barclays U.S. Agg. 6.3% 3.6% $12,705.73, HFRI Fund Weighted Composite Index $10,858.11, S&P 500 Index $6,000 $4,000 $5,131.43, Barclays U.S. Aggregate Bond Index $2,000 $0 Jan 90 Jan 91 Jan 92 Jan 93 Jan 94 Jan 95 Jan 96 Jan 97 Jan 98 Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Data sources: Hedge Fund Research (HFR); Barclays Bank PLC, 2016; S&P. S&P and its third party information providers do not accept liability for the information and the context from which it is drawn. Past performance is not necessarily indicative of future results. I09-10

Why Plans Initially Got Involved Improve Risk Adjusted Performance 60/40 Portfolio 5% Allocation to Hedge Funds 10% Allocation to Hedge Funds 15% Allocation to Hedge Funds 5% 10% 40% 60% 38% 57% 36% 54% 34% 15% 51% Asset Allocation: Time Period 01/1990 to 01/2016 60/40 Portfolio 5% to Hedge Funds 10% to Hedge Funds 15% to Hedge Funds Annualized Return 8.22% 8.16% 8.10% 8.04% Annualized Standard Deviation 9.04% 8.75% 8.45% 8.17% Sharpe Ratio 0.88 0.90 0.93 0.95 Improve plan level risk adjusted performance I09-11

Why Plans Initially Got Involved Summary Check List Diversification / Correlation Benefits Preservation of Capital / Downside Protection Reduced Equity Volatility Investment Flexibility I09-12

Considerations When ERISA Plans Invest In Hedge Funds Plan Document Considerations Who is the Fiduciary For Investment Manager or Trustees? Due Diligence Potential Contracting Pitfalls And Solutions For Benefit Plan Investors I09-13

Plan Document Considerations Do Your Plan Governing Documents Allow for this Hedge Fund Investment? Trust Agreement Investment Policy Avoid unnecessary ERISA fiduciary breach issue (ERISA Section 404(a) failure to follow plan documents) I09-14

Who is Fiduciary For Investment? Who is ERISA fiduciary for investment Trustees or Manager? Does Investment Hold Any ERISA Plan Assets? If NO, Trustees remain fiduciary for investment. If YES, Not Treated As ERISA Plan Assets if Participation By ERISA Benefit Plan Investors Less Than 25% of Investors. 25% Excludes Governmental, Certain Church and Foreign Plans. If ERISA Plan Assets over 25%, Manager is fiduciary (unless exception applies). I09-15

Exceptions To Who is Fiduciary For Investment Not Plan Assets Subject to ERISA if investment in Venture Capital Operating Company (VCOC Rules) Usually private equity strategy. VCOC is entity with at least 50% of its assets invested in venture capital investments in which it has management rights. Management rights = Rights to substantially influence management of the operating company. Must be direct rights that VCOC can exercise. Asset/management tests done annually. I09-16

Exceptions To Who is Fiduciary For Investment Not Plan Assets Subject to ERISA if investment in Real Estate Operating Company (REOC Rules). REOC is entity with 50% or more of its assets invested in qualifying real estate and directly engaged in real estate management or development activities. Tested with first investment and annually thereafter. I09-17

Hedge Fund of Fund Special Delegation Issues Named Fiduciary = Only fiduciary with ability to delegate its ERISA fiduciary duty to another entity Must be identified in Plan Document (Trust Agreement) Board of Trustees/Retirement Committee usually named fiduciary Master manager of hedge fund of funds Is master manager also a named fiduciary to delegate ERISA fiduciary duty to sub-managers/underlying investment funds? Does Trust Agreement allow designation of master manager as named fiduciary? If not, does master manager acknowledge that it is liable for submanager s actions? I09-18

Due Diligence Before Investing In Hedge Fund Investment Consultant Role Selection And Ongoing Monitoring Asset Allocation Decision Modeling And Stress Testing Look-Through Analysis Of True Risk Exposures Return expectation and timing/ J curve Lock-ups and cash flows Independent Valuation DOCUMENT PROCESS! I09-19

Issues Under Investment Contract Side Letter To Hedge Fund Investment - Documents Governs if investment fund documents inconsistent Right to see side letters of other investors Standard of Care ERISA fiduciary standard ERISA-like contractual standard ERISA-light contractual standard (prudence standard only) Indemnification By manager of Plan and Trustees? By investment fund of manager? By Trustees personally? I09-20

Issues Under Investment Contract Fees Most Favored Nations ( MFN ) Treatment on Fees, Rights and Features Fees on Un-called Capital Incentive Fees Warrant under DOL guidance? Valuation of Portfolio and Potential Conflicts Claw back How is high-water mark for payment of incentive fees set and reset? I09-21

Issues Under Investment Contract More Fees Unrelated Business Taxable Income Effort to avoid? Protections if taxable income is earned? Impact of tax on net return/incentive fee? Imposition of Organizational and Operating Expenses Charged to investor or manager absorbs? Capped? If early investor, spread to later investors? I09-22

Issues Under Investment Contract Confidentiality Of Plan s information? Of Plan s identity? Reporting Sufficient for ongoing monitoring by investment consultant? Financial statements of underlying investments? Section 101(k) for multiemployer plans? I09-23

Issues Under Investment Contract Conflicts of Interest Avoided, either by ERISA or by contract? Limits on hiring its affiliates for middle & back-office services? Fees from underlying investments/investment managers? Valuation by independent entity Scope of other agent s liability (administrator, custodian, board of directors) I09-24

Issues Under Investment Contract Voting Pro-rata? Control over changes in future? Investor Advisory Councils Right to position (if desired) Involuntary Redemptions Allowed? At any time? For limited reasons or manager s complete discretion? I09-25

Issues Under Investment Contract How To Get Out? No Fault Divorce/Liquidity When and with What Notice? Lock Up? Liquidation impractical or inadvisable? Extended beyond initial term? If so, who decides? Unilateral by manager as GP or vote of investors? What is Fund getting in kind or cash? If in kind, who manages until liquidated and for what fee? I09-26

Hedge Funds as Return Enhancers or Help Reduce Volatility? Limited Recent Outperformance (Alpha) Compared to Public Markets Annualized net returns by calendar year 2010 2011 2012 2013 2014 2015 YTD 2016 HFRI FW Composite 10.3% 5.3% 6.4% 9.1% 3.0% 1.1% 3.5% S&P 500 15.1% 2.1% 16.0% 32.4% 13.7% 1.4% 7.8% Barclays U.S. Agg. 6.6% 7.8% 4.2% 2.0% 6.0% 0.6% 5.9% Rolling period returns and volatility Trailing 1 year Trailing 3 years Trailing 5 years Ann. return Volatility Ann. Return Volatility Ann. Return Volatility HFRI FW Composite 2.8% 4.6% 3.6% 4.0% 3.5% 4.6% S&P 500 12.6% 12.4% 12.3% 10.7% 14.7% 11.6% Barclays U.S. Agg. 6.0% 2.2% 4.4% 2.6% 3.2% 2.6% Data sources: Hedge Fund Research (HFR); Barclays Bank PLC, 2016; S&P. S&P and its third party information providers do not accept liability for the information and the context from which it is drawn. Past performance is not necessarily indicative of future results. I09-27

Hedge Fund Performance V-Shaped Markets Over The Last Year Significant up and down fluctuations in equity markets July 2015 June 2016 2200 S&P 500 Index Level 2100 2000 12.2% +13.0% 13.3% +15.9% 6.4% 1900 1800 Jul 15 Oct 15 Jan 16 Apr 16 Data sources: S&P. S&P and its third party information providers do not accept liability for the information and the context from which it is drawn. I09-28

Hedge Funds Performance Saturation Impact on Market Efficiency 10,000 Growth of Hedge Fund & ETFs Over Time $3,500 Select Reasons for ETF Proliferation Simplicity Number of Hedge Funds 9,000 8,000 7,000 6,000 5,000 4,000 3,000 $3,000 $2,500 $2,000 $1,500 $1,000 AUM ($ bil) Enhanced Liquidity Speed of Execution Diversification Attractive fees Select Risks of ETF Proliferation 2,000 1,000 $500 Market instability 0 $- Market efficiency Number of Hedge Funds Hedge Fund AUM ($ bil) ETF AUM ($ bil) Herd mentality Source: Eurekahedge, Preqin, http://www.statista.com/statistics/224579/worldwide etf assets under management since 1997/, Global Trends in Institutional ETF Adoption: Drivers from Growth Through 2020 (Greenwich Associates) I09-29

Hedge Funds Performance Efficient Markets Impact Performance S&P 500 Dispersion CY 2008 - CY 2015 100% 80% 87% 77% 80% 91% 74% 60% 40% 51% 44% 20% 8% 0% -20% -40% -13% -23% -20% -9% -26% -60% -80% -49% -56% -100% -92% 2008 2009 2010 2011 2012 2013 2014 2015 I09-30

Hedge Funds Performance Over-Diversification? Similar Fund Characteristics? 1 3 6 25 50 8,000+ Traditional Multi Strategy HFOF Vehicle Month Liquidity Provisions (On Average) Underlying Hedge Fund Investments Underlying Security Investments (Long & Short) Source: Lighthouse Partners, K2 Advisors I09-31

Commitment to Hedge Funds Today How Investors View Hedge Funds Investors intentions for their hedge fund allocations in next 12 months 100% 80% 29% 35% 38% 33% 32% 26% 25% Proportion of Investors 60% 40% 51% 54% 53% 47% 60% 58% 44% Increase allocation Maintain allocation Decrease allocation 20% 32% 20% 20% 16% 10% 9% 8% 0% Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15 Source: Preqin Hedge Fund Investor Interviews Source: The 2016 Preqin Global Hedge Fund Report. I09-32

35% 30% 25% 20% 15% 10% 5% 0% Commitment to Hedge Funds Today How the Investment Consultant Community Views Hedge Funds Recommended Portfolio Allocation to HFs (as % of AUM) 12% 24% 32% 20% 8% 4% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Investment Consultant Recommendations for HF Allocations, 2014 vs. 2015 15% 17% 45% 40% 58% 25% 2014 2015 Recommended Clients Invest Less Capital in HFs than in Previous Year Recommended Clients Invest the Same Amount of Capital in HFs as in Previous Year Recommended Clients Invest More Capital in HFs than in Previous Year Despite recent performance struggles, institutions and consultants alike remain steadfast in their pursuit of hedge fund like exposures as critical components of broader portfolios. Source: 2016 Preqin Global Hedge Fund Report I09-33

Despite Recent Performance, Hedge Fund Industry Is Stable AUM (left) and number of funds (right) January 1990 June 2016 $3,000 As of June 30, 2016: 9,000 $2,500 $2,000 AUM: $2,898 billion Count: 8,406 hedge funds 7,500 6,000 $1,500 4,500 $1,000 3,000 $500 1,500 $0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2Q 2016 Estimated Hedge Fund Assets ($ billions) Estimated Number of Hedge Funds Source: HFR Global Hedge Fund Industry Report Second Quarter 2016 HFR, Inc. 2016, www.hedgefundresearch.com. 0 I09-34

Evolving Hedge Fund Investment Landscape Improved partnership between managers and investors Customization Transparency Fees Portfolio concentration New strategies blur the lines of PE vs. HF vs. traditional investing Regulatory changes Increase in talent leaving banks to join hedge funds Hedge funds replacing banks as longer-term liquidity providers Hedge Fund Alternatives I09-35

Potential Headwinds for Traditional Assets? Equity markets High equity market valuations Price to earnings ratios remain high 20 19 S&P 500 Index Trailing Quarter P/E Ratio 18 17 16 15 Trailing 5 year average: 16.6 14 13 12 Jul 11 Jul 12 Jul 13 Jul 14 Jul 15 Jul 16 Declining earnings growth Year over year earnings per share growth has turned negative 25% 20% 15% 10% 5% 0% S&P 500 Index Trailing 12 Month Weighted EPS Growth Trailing 5 year average: 6.8% 5% Jul 11 Jul 12 Jul 13 Jul 14 Jul 15 Jul 16 Fixed income markets Potential for rising bond yields and falling bond prices Government bond yields continue to compress 7% 6% 5% 4% 3% 2% 1% U.S. 10 year Treasury Note Average since 2000: 3.7% Potential for widening credit spreads and increasing defaults High yield spreads near pre crisis levels 0% 0 bp Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Jan 16 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Jan 16 Data sources: Federal Reserve Bank of St. Louis; Credit Suisse; Bloomberg Finance L.P.; S&P. S&P and its third party information providers do not accept liability for the information and the context from which it is drawn. These opinions represent our good faith expectations concerning future actions, events or conditions, and should not be viewed as indications of whether particular actions, events or conditions will occur. I09-36 2000 bp 1500 bp 1000 bp 500 bp Credit Suisse High Yield Spread to Worst Average since 2000: 638 bp?

Setting the Stage for the Future Capital Market Assumptions Asset Classes 2016 Assumptions 2011 Assumptions Difference 2016 Standard Deviation/Risk Equity U.S. Large Cap 6.6% 9.3% 2.7% 16.9% Emerging Markets 8.5% 12.5% 3.0% 26.4% Fixed Income Core 3.4% 4.2% 0.8% 6.0% Alternatives Hedge Fund of Funds 5.4% 7.4% 2.0% 8.4% Source: Horizon Actuarial Services, LLC 2016 Survey of Capital Market Assumptions I09-37

Greater Macroeconomic Uncertainty Why we might see increased global equity/credit market dispersion: Slower economic growth globally Diverging global monetary policies Unprecedented central bank actions Binary macro events like Brexit Geopolitical risks globally Potential for U.S. interest rate hikes Detrimental effects of negative interest rates in Europe and Japan Decline in inflationary expectations globally Rising risk of credit-driven crises due to high leverage levels (China) Technical factors increasingly driving stock valuations These opinions represent our good faith expectations concerning future actions, events or conditions, and should not be viewed as indications of whether particular actions, events or conditions will occur. I09-38

Incorporating Hedged Investment Solutions Today Hedge Fund-Like Investments Across the Liquidity Spectrum Hedge fund like exposures come in various shapes, sizes, and liquidity profiles today. Traditional multi strategy HFOF vehicles remain viable, but other solutions exist across the spectrum. Beta / Volatility Risk Illiquidity Risk Liquid Alternatives Risk Parity GTAA Style Premia Equity Options 40 Act Alternative Mutual Funds Other HFOFs / Direct HFs Multi Strategy Strategy Specific Sector Specific Region Specific Illiquid Alternatives Opportunistic I09-39

Session #I09 The Pros and Cons of Hedge Funds Be Sure Your Plan Document Allows The Hedge Fund Investment Know Who is Fiduciary For Investment Manager or Trustees? Complete and Document Due Diligence Negotiate Over Contracting New Investors Understand What is the Role of the Hedge Fund Allocation Existing Investors Review Why were Hedge Funds Added Review Whether or Not Hedge Funds have Met Goals Have Goals or Expectations Changed? Consider Recent Hedge Fund Performance in Light of Current and Potential Market Conditions Understand the Evolution of Hedge Fund Products and Alternatives Including a Consideration of Liquidity Needs 62nd Annual Employee Benefits Conference November 13-16, 2016 Orlando, Florida I09-40

2017 Educational Programs Investments 63rd Annual Employee Benefits Conference Portfolio Concepts and Management www.ifebp.org/usannual www.ifebp.org/wharton October 22-25, 2017 Las Vegas, Nevada May 1-4, 2017 Philadelphia, Pennsylvania Investments Institute March 13-15, 2017 Phoenix, Arizona www.ifebp.org/investments Related Reading Visit one of the on-site Bookstore locations or see www.ifebp.org/bookstore for more books. The Tools & Techniques of Investment Planning, 3rd Edition Item #9029 www.ifebp.org/books.asp?9029 I09-41 816