Hedge fund industry: is there a capacity effect?

Hedge fund industry: is there a capacity effect? July 2005 Rudy Sillam Edhec Risk and Asset Management Research Centre

CONTENTS Foreword 1 Executive summary 2 Hedge fund industry: is there a capacity effect? 3 Introduction 3 Survey methodology 5 Have some strategies reached saturation point? 6 The alpha problem 7 Talented managers 9 Size effect? 9 Conclusion 10 References 11 Appendix: Statistical results 12 Edhec Risk and Asset Management Research Centre 20 Copyright Edhec 2005

FOREWORD: Capacity Effect or Incapacity Effect? For several months, investors and their advisors have been worrying about the profitability prospects for hedge funds. Modestly entitled the "capacity effect", the analysis of the reasons behind the fairly disappointing performance in 2004 constitutes, if we believe those who are putting the argument forward, a serious calling into question of the alternative investment industry's value proposition. Alphas would be tending to become rarer, for two main reasons: The significance of the sums drained into the alternative investment industry are making the implementation of "niche arbitrage" strategies more and more difficult (for example, convertible bonds or arbitrage on small stocks); more globally, the increase in operational volumes is reducing market inefficiency and market anomalies, which are allegedly the main source of performance for hedge funds. The windfall represented by the remuneration model and the very strong growth in assets under management is attracting more and more managers, which is leading to a dilution of the talent available in the industry. The "democratisation" of hedge funds is making them increasingly dull. However, this pessimism doesn't hold up when we examine the facts. It is related more to the incapacity on the part of both investors and managers to understand or explain the true benefits of investment in hedge funds than to the capacity effect. The capacity problem that is supposedly linked to the disappearance of arbitrage opportunities has not been demonstrated and cannot, in our opinion, be demonstrated. On the one hand, the alternative industry, even taking the leverage effects into account, represents less than 2% of worldwide stock market capitalisation and, on the other, even when considering specific market segments (the raw material derivatives market, stock loan/borrowing market, etc.), it is true that one can reach very significant proportions of activity relating to the intervention of hedge funds, representing up to 3 of operations on certain stocks or up to 5 of some open positions, but these volumes rarely correspond to arbitrage operations. They generally involve bets that are directional (CTA, Global Macro) or related to the unfolding of events on securities that by definition are intended to move between market segments in accordance with speculative opportunities. In certain situations, hedge fund profits can be limited by the depth of the market, but it is not strictly speaking a reduction in inefficiency, simply a concern on the part of managers not to be the only providers of liquidity. It has not been demonstrated either that the new entrants into the industry have less talent than the initial entrants. Academic research and empirical work on the "age" effect on hedge fund performance gives conflicting results. Besides, estimating a hypothetical increase in the number of fund failures is not possible either, given the reporting biases and the insufficiencies of databases in this area. In fact, the essential part of hedge fund performance comes from their betas. Their talent resides in the management of those betas, namely, correctly taking risks for which the premiums, i.e. the "normal" returns, are less easy to capture in the equity and bond markets. Allowing investors, for example, to access the credit and volatility markets in good timing and price conditions undeniably constitutes added value which justifies turning to specialists. Even the performances of so-called "Relative Value" strategies such as Long/Short Equity and Equity Market Neutral are conditioned by bets on particular risks like, for example, the evolution of the Large Cap - Small Cap spread. By constantly highlighting arbitrage alphas that are difficult to measure, hedge funds have themselves fallen into the trap of the capacity effect, with the risk of forgetting their true virtue - that of offering new betas to investors who are always looking for effective diversification. The aim of the current survey, which follows a recent Edhec research paper by Walter Géhin and Mathieu Vaissié entitled The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy, was to check whether the opinions on the capacity effect of the finance professionals in the field, and their views on the real sources of hedge fund performance, corresponded to the results of our research in this area. Noël Amenc, PhD Professor of Finance at Edhec & Director of the Edhec Risk and Asset Management Research Centre Hedge fund industry: is there a capacity effect? 1

EXECUTIVE SUMMARY Introduction Following recent studies claiming that the hedge fund industry will suffer from a capacity effect, the Edhec Risk and Asset Management Research Centre published a paper entitled "The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy", which refuted the idea of capacity constraints within the industry and promoted the importance of alternative betas in hedge funds' returns, rather than focusing exclusively on alpha. In order to analyse the opinions of industry professionals and academics, we decided to conduct a survey to try to respond to the question: Is there a capacity effect within the industry? Market capacity Most of our respondents think that only relative value arbitrage strategies suffer or will suffer from a capacity constraint. These results are in line with the impact of hedge funds in different markets, with overall hedge fund industry assets representing no more than 3% of worldwide financial assets, but accounting for up to 9 of the trading in the markets for relative value arbitrage strategies. Moreover, our respondents are confident about the growth prospects of the industry, with more than 65% expecting double-digit annual growth rates. The Alpha problem While investors seem preoccupied with the problem of alpha, they are aware of where hedge fund performance comes from. Approximately half of the respondents think that alpha is the main source of performance within the industry, but 95% of the respondents think that alpha is overestimated and they are aware of hedge funds' exposures to alternative betas as a source of return (69.8% of our respondents). Moreover, as the study by Gehin and Vaissié (2005) has shown, most of the respondents agree that alternative betas are predominant in relative value arbitrage strategies, and they find that cyclical factors (for 69.7% of our respondents), rather than a disappearance of "pure alpha", explain the disappointing performance that these strategies have experienced recently. Manager capacity and size effect While a market capacity problem seems to be refuted by our respondents, the results regarding the problem of manager capacity are mixed. Although the industry does not suffer from a shortage of talent, the huge growth in the number of hedge funds has increased the difficulty of selecting talented managers. Moreover, our respondents do not think that a critical hedge fund size exists within the industry. Conclusion The results of our survey show that the hedge fund industry is not suffering from a capacity constraint but is facing new challenges. The hedge fund industry has to understand that returns come more from the exposure to alternative risk premiums rather than alpha, and that the main advantages to investing in hedge funds relate to their diversification benefits with traditional assets (approximately 6 of our respondents invest in hedge funds for their diversification benefits with traditional assets). Moreover, the industry is maturing and becoming more competitive as 81% of our respondents claim. With professionalism and innovation, the hedge fund industry is more likely to keep growing and create high and stable returns. 2 Hedge fund industry: is there a capacity effect?

HEDGE FUND INDUSTRY: IS THERE A CAPACITY EFFECT? Introduction During the last five years, the hedge fund industry has experienced tremendous growth, with an average annual growth rate of 15%. According to Van Hedge Fund Advisors, the industry went from 6,200 funds representing $480 billion in assets under management (AUM) in 1999 to 8,700 funds representing $950 billion in AUM at the end of 2004. Moreover, analysts forecast that the industry will represent $1.7 trillion in assets in 2008 with more than 11,000 funds. The current 8,700 funds use different strategies, naturally, to manage their assets. Among these strategies, Long/Short Equity represents more than 33% of hedge fund industry assets (see exhibit 1). Exhibit 1: Breakdown of assets under management by strategy in the hedge fund universe 8% 11% 7% 5% 33% 7% 7% 7% Convertible Arbitrage CT A Global Emerging Markets Equity Market Neutral Event Driven Fixed Income Arbitrage Funds of Funds Global Macro Long/Short Equity Short Selling Other Source: Hedge Fund Research, Watson Wyatt (2005) 15% Hedge fund industry: is there a capacity effect? 3

After good returns in 2003 (11.45% for the EDHEC Fund of Funds Index, see exhibit 2), the industry has experienced decreasing positive performance in 2004 (7.08% for the EDHEC Fund of Funds Index) with even negative returns in the second quarter of 2004. These returns, confirmed by the returns of April 2005, have led some investors to talk about a capacity effect in the industry, claiming that the industry is a victim of its success and therefore that market opportunities will disappear and talented managers will be more difficult to find. The four major arguments behind this supposed capacity effect are the following: In some strategies, the huge number of players has reduced market opportunities Due to the capacity constraint, alpha is disappearing There is a shortage of talent in the industry to cope with the growth of assets Size is becoming a problem In order to analyse the arguments relating to the problem of capacity in the industry, we conducted a survey among investment professionals who have an interest in the hedge fund industry. The results produced by our survey are in line with those of the Gehin and Vaissié study, "The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy", which affirmed that the reduction in the number of market opportunities and the capacity effect are false problems and that recent disappointing performances come more from cyclical factors (for 69.7% of our respondents) than a reduction in market opportunities and more generally that hedge fund performance comes more from exposure to alternative risk factors (alternative betas) than from pure alpha. Exhibit 2: Historical returns of EDHEC Indices by strategy Edhec Indices Y 2002 Y 2003 Q2 2004 Y 2004 Q1 2005 April 2005 Convertible Arbitrage Annual Average Return since Inception 8.6 10.8-2.13% 1. -2.91% -3.16% 6.18% CTA Global 14.57% 11.64% -9.39% 5.17% -4.39% -3.54% 6.31% Distressed Securities 5.86% 27.34% 2.87% 17.89% 2.04% -0.52% 14.36% Emerging Markets 5.76% 31.27% -4.09% 14.3 2.87% -0.49% 14.32% Equity Market Neutral 4.71% 6.29% -0.16% 4.71% 1.81% -0.3 5.72% Event Driven -1.08% 20.48% 0.92% 12.43% 1.44% -1.28% 8.98% Fixed Income Arbitrage 7.56% 8.35% 1.58% 6.26% 1.54% -0.03% 7.06% Funds of Funds 1.26% 11.45% -1.16% 7.08% 0.97% -1.41% 5.12% Global Macro 4.96% 17.25% -2.76% 4.6 0.96% -0.8 7.2 Long/Short Equity -6.38% 19.31% -1. 8.62% 0.95% -1.84% 4.16% Merger Arbitrage -0.9 8.34% -0.22% 4.83% 0.97% -1.05% 3.41% Relative Value 2.77% 12.15% -0.6 5.71% 0.51% -1.08% 6.41% Short Selling 27.27% -23.87% 3.06% -4.66% 7.66% 3.93% 4.2 Source: Edhec Risk and Asset Management Research Centre 4 Hedge fund industry: is there a capacity effect?

Survey Methodology In this survey, conducted from May 31st to July 8th 2005, we sent out an email to financial professionals informing them that our questionnaire was available at www.formdesk.com/edhecrisk/capacityeffect and asking them to participate in the survey. We collected 183 responses, of which 65.6% work in funds of hedge funds and 10.9% in hedge funds. 11.5% of our respondents are institutional investors and 12% work in a consulting or research company (see exhibit 3). Statistical results are given in the appendix. Exhibit 3: Breakdown of respondents by category 12. 11.5% 10.9% 65.6% Institutional Investors Hedge Funds Funds of Hedge Funds Others (advisors, consultants ) Source: Edhec Risk and Asset Management Research Centre Hedge fund industry: is there a capacity effect? 5

Have some strategies reached saturation point? To the question, "Of the following strategies, which suffer or will suffer from a capacity constraint?", results show that relative value arbitrage strategies may suffer from a capacity effect. Indeed, for 83.2% and 65.92% of the respondents respectively, the convertible arbitrage and merger arbitrage strategies suffer from a capacity constraint (see graph 9 below). Moreover, for 70.9% of the respondents, arbitrage opportunities have been reduced and will be difficult to exploit (see graph 8 below). These results are in line with the impact of hedge funds in different markets. Even if the hedge fund industry represents $1 trillion in assets today, the size of the industry remains small in comparison with the overall asset management industry. According to UBS, the worldwide financial market (equities + bonds) represents $87.4 trillion in assets, which means that the hedge fund industry represents only 1.1% of total financial assets. Moreover, if we include the use of leverage, the industry still represents no more than 3% of total financial assets. For instance, hedge fund investing in equities represents a mere 2% of the equity market. However, we have to note that professionals seem confident about the future of the industry and its capacity to keep growing. More than 65% of the respondents (see graph 2 below) think that industry assets will grow at a minimum annual rate of over the next five years with a large number of respondents putting this growth at between and 15%. The main reasons behind this belief that the industry will continue to grow at a double-digit annual rate are the capital inflows from institutional investors and the increase in regulation (48% of respondents) and the benefits of hedge funds in comparison with traditional investment (2). We should recall that the growth of the industry during the past five years was 15% per year. Therefore, most people expect to see the industry continue to grow at the same rate. If we look at relative value strategies, some arbitrage strategies can represent a huge share of the assets and trading. For example, convertible arbitrage funds account nowadays for 7 to 9 of the trading in the convertible market, and in 2004 and the first quarter of 2005 the strategy has experienced its worst returns since the LTCM crisis in 1998 (annual return of 1.1% for the EDHEC Convertible Arbitrage index in 2004 and a negative return of -2.91% for the first quarter 2005 against an historical average annual return of 6.18%). Market opportunities seem to have been eroded in these markets and "pure alphas" may be more difficult to find due to the huge number of players. 6 Hedge fund industry: is there a capacity effect?

The alpha problem For those claiming that the industry is suffering from a capacity constraint, the main problem would seem to be that alpha (manager skill) is becoming rarer. The results of our survey show that while investors seem preoccupied with the problem of alpha, the main concern in the industry now is to evaluate this alpha and to understand the benefits of hedge funds. We have seen previously that "pure alphas" seem to be difficult to find because some strategies may be overcrowded. However, no more than 53.3% of the respondents think that alpha is the main source of performance within the industry (see graph 3 below). Moreover, 95% of the respondents think that alpha, through poor measurement of different risk exposures, could be overestimated (see graph 6 below), showing that alpha is not such a major source of returns and that exposure to different risk exposures plays an important role in explaining returns. As Fung (2003) says, " hedge funds deliver alternative risk premia for bearing risk in factors different from traditional investment ", Indeed, 69.8% of respondents are aware of "alternative betas" i.e. betas coming from exposure to risk factors other than market risk (see graph 4 below). Not surprisingly, 74% of the respondents who are aware of alternative betas claim that alternative betas are predominant in relative value arbitrage strategies, mainly in convertible arbitrage (58.33%, see graph 5 below) and fixed income arbitrage strategies (5). Therefore, we can wonder whether the disappointing performance that these strategies have experienced recently are due to a reduction in the risk premiums with regard to the systematic risks that these funds are taking (credit risk, volatility risk, etc., see exhibit 4) rather than to "pure alpha" that would be becoming difficult to produce due to a shortage of market opportunities and to overcrowding in these strategies. These results confirm the analysis in Gehin and Vaissié (2005), which indicated that 103.17% and 95.81% of the performance level of Convertible Arbitrage funds and Fixed Income Arbitrage funds, respectively, comes from their exposures to static betas (see exhibit 5). by for instance being exposed to volatility risk, default risk or liquidity risk. Hedge fund industry: is there a capacity effect? 7

Equity Factors Bond Factors Other Exhibit 4: Exposure to risk factors by strategy From January 1997 to December 2004 Implied volatility (VIX) Change in Implied Volatility (VIX) Value versus Growth Change in Value Versus Growth Small Cap versus Large Cap Equity Market Neutral + + + + + - - + + Fixed Income Arbitrage + + - - - Convertible Arbitrage + - + - + + Merger Arbitrage + + + + - - - + Distressed Securities + - + + - Long/Short Equity + + - + + - - - + Global/Macro + + + - + - - + - CTA Global + - - + + - + Emerging Markets + + + + - Change in Small Cap versus Large Cap S&P 500 Term Spread Change in Term Spread Credit Spread Source: Edhec Risk and Asset Management Research Centre Change in Credit Spread Lehman Global Bond Index (Bond Return) Historical Volatility in Bond Return T-Bill 3 Months US Dollar Commodity Index Exhibit 5: Decomposition of Hedge Fund Strategies' Return Variability From January 1997 through December 2004 Investment Styles Static Betas Dynamic Betas Pure Alpha Total Convertible Arbitrage 42.13% 21.15% 36.72% 100.0 CTA Global 26.97% 34.6 38.43% 100.0 Distressed Securities 66.76% 8.62% 24.62% 100.0 Emerging Markets 60.91% 14.74% 24.35% 100.0 Equity Market Neutral 51.53% 27.37% 21.09% 100.0 Fixed Income Arbitrage 37.28% 36.32% 26.39% 100.0 Global Macro 35.49% 34.52% 29.99% 100.0 Long/Short Equity 83.06% 9.25% 7.7 100.0 Merger Arbitrage 59.51% 26.21% 14.29% 100.0 Average 51.52% 23.64% 24.84% 100.0 Source: Edhec Risk and Asset Management Research Centre 8 Hedge fund industry: is there a capacity effect?

Talented managers The third argument behind the problem of capacity constraint within the industry would be that the industry suffers from a lack of talented individuals. According to Watson Wyatt (2005), no more than of current hedge fund managers are highly skilled. With the increase in the number of funds and the fact that many managers with good track records are closed to new investment, the argument would be that fund of hedge funds managers would have more difficulty finding talented hedge fund managers only and their future returns would be expected to go down. The results of our survey show mitigated opinions. 59.3% of respondents find it difficult today to select talented managers (see graph 10 below), but only 36.3% of the respondents claim that the manager capacity constraint is an important threat to returns in the industry (see graph 11 below). It appears that the industry suffers more from the proliferation of funds, which leads investors to improve their fund selection process in order to find talented managers, rather than from a shortage of talented managers. Size effect? Even if research on the "age" and "size" effect shows varying results, an argument of those alleging that the industry suffers from a capacity effect is that size would impact the fund performance and therefore that there would be a critical size for a fund. Our results seem to refute this idea. Half of the respondents think that there is no size limit for a fund of hedge funds, whereas the other half thinks that a critical size exists (see graph 13 below). However, those who think that a critical size exists differ in their definition of the critical size (see graph 14 below). For 23.2% of these respondents the critical size of the fund of hedge funds depends on the underlying strategies. For 18.3% the size is around $500 million and for 22% the critical size is between $1 billion and $2 billion. 40.2% of the funds of hedge funds questioned are willing to buy or merge with a competitor in order to gain capacity in the industry (see graph 15). Hedge fund industry: is there a capacity effect? 9

CONCLUSION Capacity constraint in the hedge fund industry is currently a matter of concern to investment professionals. However, as the results of our survey show, the industry does not suffer from a capacity constraint but is facing new challenges. 69.8% (see graph 7 below) of our respondents consider that cyclical factors were among the main reasons behind recent lower-than-expected returns (for 42.3% of our respondents cyclical factors were the only reason). This corresponds to the conclusions of Fransolet and Loeys (2004), for whom many of the current low returns of hedge funds are due to cyclical factors which prevent the emergence of momentum or large mispricing opportunities (no major change in economic views, low volatility, high correlation in markets, low credit spreads, etc.). Investing in hedge funds offers several benefits but has its risks. Hedge fund managers are not magicians who provide excess returns without taking any risk. They are managers who create returns by exploiting alternative risk premiums and offer the benefits of diversification for an investor's portfolio (for 53.5% and 47.7% of our respondents respectively, the benefits of hedge funds come from their diversification benefits with equities and bonds, see graph 1 below). Moreover, the hedge fund industry is maturing and becoming more competitive, with institutional investors' current interest in the industry, the high fees that have characterised the business and increasing regulations. As 81.3% of our respondents acknowledge (see graph 12 below), the hedge fund industry is becoming more professional. With professionalism and innovation, the industry is more likely to keep growing and creating high and stable returns. However, as Lo (2004) says, " new opportunities are constantly being created as certain species die out, as others are born, and as institutions and business conditions change ". By exploiting opportunities in different markets and therefore increasing liquidity in these markets, hedge funds reduce some opportunities, but at the same time create new ones. 10 Hedge fund industry: is there a capacity effect?

REFERENCES Géhin, W. and Vaissié, M., "The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy", Edhec Risk and Asset Management Research Centre, June 2005. UBS, "The Critique of Pure Alpha", March 2005. Watson Wyatt, "Capacity in the Hedge Fund Industry", March 2005. Hedge fund industry: is there a capacity effect? 11

APPENDIX: STATISTICAL RESULTS 7 Graph 1 1. If you invest in hedge funds, why do you do so? 6 53.5% 60. 5 47.7% 4 3 2 21.8% 32.9% 21.2% 10.6% For their diversification benefits with bonds For their diversification benefits with equities Hedge funds offer absolute returns Better performance on average than that of traditional funds The volatility of hedge fund performance is lower than that of traditional assets The potential for maximal loss is lower than for traditional assets Other Graph 2 2. At what average annual rate do you expect hedge fund industry assets to grow over the next 5 years? 5 45% 4 35% 3 25% 2 25.8% 36.3% 20.3% 15% 5% 2.2% 6. 6. 3.3% Less than Between and 5% Between 5% and Between and 15% Between 15% and 2 Between More than 2 and 25% 25% Expected growth 12 Hedge fund industry: is there a capacity effect?

Graph 3 3. To your mind, is alpha (manager skill) the main source of performance within the hedge fund industry? 6 5 4 3 2 53.3% Yes 46.7% No Graph 4 4. Are you aware of what are referred to as alternative betas (betas coming from exposure to risk factors other than market risk)? 8 7 69.8% 6 5 4 3 2 30.2% Yes No Hedge fund industry: is there a capacity effect? 13

Graph 5 7 6 5. Within which strategies do you think that alternative betas are predominant? 58% 5 4 3 2 5 39% 28% 33% 28% 4 31% 25% 26% 29% 25% Convertible Arbitrage Fixed Income Arbitrage Merger Arbitrage Relative Value Distressed Securities Event Driven Long/Short Equity Equity Market Neutral Short Selling Emerging Markets Global Macro CTA Global Graph 6 6. Do you think that alpha, through poor measurement of different risk exposures, could be overestimated? 10 95.05% 9 8 7 6 5 4 3 2 4.95% Yes No 14 Hedge fund industry: is there a capacity effect?

Graph 7 7. Do you think that the lower-than-expected returns in 2004 were due to cyclical factors or to capacity constraints? 45% 42.3% 4 35% 3 25% 2 15% 20.9% 27.5% 9.3% 5% Cyclical factors Capacity constraints Both Other Graph 8 8. Do you think that arbitrage opportunities will be difficult to find in future years due to capacity constraints? 8 7 70.9% 6 5 4 3 2 29.1% Yes No Hedge fund industry: is there a capacity effect? 15

Graph 9 9. Of the following strategies, which suffer or will suffer from a market capacity constraint? 9 83% 8 7 66% 6 5 4 3 2 41% 15% 24% 41% 45% 23% 5% 19% 4 11% Convertible Arbitrage CTA Global Distressed Securities Emerging Markets Equity Market Neutral Event Driven Fixed Income Arbitrage Funds of Funds Global Macro Long/Short Equity Merger Arbitrage Relative Value Short Selling Graph 10 10. Do you find it more difficult today to find talented hedge fund managers? 7 6 59.3% 5 4 3 2 40.7% Yes No 16 Hedge fund industry: is there a capacity effect?

Graph 11 11. What is the main threat for returns in the industry? 5 45% 4 35% 3 25% 2 15% 5% 36.3% Manager capacity constraints (manager skill) 43.4% Market capacity constraint (size of the industry) 20.3% Other Graph 12 12. Do you think that the hedge fund industry is becoming more professional? 9 8 81.3% 7 6 5 4 3 2 18.7% Yes No Hedge fund industry: is there a capacity effect? 17

Graph 13 13. Do you think that there is a critical size for a fund of hedge funds? 5 50.55% 49.45% 4 3 2 Yes No Graph 14 14. Critical size for a fund of hedge funds 35% 3 25% 2 15% 12.2% 18.3% 12.2% 9.8% 8.5% 15.85% 23.2% 5% Less than $300 million Around $500 million Around $1 billion Around $2 billion Around $5 billion Other size Depends on the strategies 18 Hedge fund industry: is there a capacity effect?

Graph 15 15. If you are a fund of hedge funds, are you willing to buy or merge with a competitor in order to gain capacity in the industry? 7 6 59.8% 5 4 3 2 40.2% Yes No Hedge fund industry: is there a capacity effect? 19

EDHEC RISK AND ASSET MANAGEMENT RESEARCH CENTRE Edhec is one of the top five business schools in France owing to the high quality of its academic staff (over 100 permanent lecturers from France and abroad) and its privileged relationship with professionals that the school has been developing since it was established in 1906. Edhec Business School has decided to draw on its extensive knowledge of the professional environment and has therefore concentrated its research on themes that satisfy the needs of professionals. Edhec is one of the few business schools in Europe to have received the triple international accreditation: AACSB (US-Global), Equis (Europe-Global) and AMBA (UK-Global). Edhec pursues an active research policy in the field of finance. Its Risk and Asset Management Research Centre carries out numerous research programmes in the areas of asset allocation and risk management in both the traditional and alternative investment universes. The choice of asset allocation The Edhec Risk and Asset Management Research Centre structures all of its research work around asset allocation. This issue corresponds to a genuine expectation from the market. On the one hand, the prevailing stock market situation in recent years has shown the limitations of active management based solely on stock picking as a source of performance. On the other, the appearance of new asset classes (hedge funds, private equity), with risk profiles that are very different from those of the traditional investment universe, constitutes a new opportunity in both conceptual and operational terms. This strategic choice is applied to all of the centre's research programmes, whether they involve proposing new methods of strategic allocation, which integrate the alternative class; measuring the performance of funds while taking the tactical allocation dimension of the alphas into account; taking extreme risks into account in the allocation; or studying the usefulness of derivatives in constructing the portfolio. Percent of variation between funds 11. 3.5% Strategic Asset Allocation 40. Tactical Asset Allocation Stock Picking 45.5% Fees Source: Edhec (2002) and Ibbotson, Kaplan (2000) 20 Edhec Risk and Asset Management Research Centre

An applied research approach In a desire to ensure that the research it carries out is truly applicable in practice, Edhec has implemented a dual validation system for the work of the Risk and Asset Management Research Centre. All research work must be part of a research programme, the relevance and goals of which have been validated from both an academic and a business viewpoint by the centre's advisory board. This board is made up of both internationally recognised researchers and the centre's business partners. The management of the research programmes respects a rigorous validation process, which guarantees both the scientific quality and the operational usefulness of the programmes. To date, the centre has implemented six research programmes: Multi-style/multi-class allocation This research programme has received the support of Misys Asset Management Systems, SG Asset Management and FIMAT. The research carried out focuses on the benefits, risks and integration methods of the alternative class in asset allocation. From that perspective, Edhec is making a significant contribution to the research conducted in the area of multi-style/multiclass portfolio construction. Performance and style analysis The scientific goal of the research is to adapt the portfolio performance and style analysis models and methods to tactical allocation. The results of the research carried out by Edhec thereby allow portfolio alphas to be measured not only for stock picking but also for style timing. This programme is part of a business partnership with the firm EuroPerformance (part of the Fininfo group). Indices and benchmarking Edhec carries out analyses of the quality of indices and the criteria for choosing indices for institutional investors. Edhec also proposes an original proprietary style index construction methodology for both the traditional and alternative universes. These indices are intended to be a response to the critiques relating to the lack of representativity of the style indices that are available on the market. Edhec was the first to launch composite hedge fund strategy indices as early as 2003. The indices and benchmarking research programme is supported by AF2I, Euronext, BGI, BNP Paribas Asset Management and UBS Global Asset Management. Asset allocation and extreme risks This research programme relates to a significant concern for institutional investors and their managers that of minimising extreme risks. It notably involves adapting the current tools for measuring extreme risks (VaR) and constructing portfolios (stochastic check) to the issue of the long-term allocation of pension funds. This programme has been designed in co-operation with Inria's Omega laboratory. This research programme also intends to cover other potential sources of extreme risks such as liquidity and operations. The objective is to allow for better measurement and modelling of such risks in order to take them into consideration as part of the portfolio allocation process. Asset allocation and derivative instruments This research programme focuses on the usefulness of employing derivative instruments in the area of portfolio construction, whether it involves implementing active portfolio allocation or replicating indices. "Passive" replication of "active" hedge fund indices through portfolios of derivative instruments is a key area in the research carried out by Edhec. This programme is supported by Eurex and Lyxor. ALM and asset management This programme concentrates on the application of recent research in the area of asset liability management for pension plans and insurance companies. The research centre is working on the idea that improving asset management techniques and particularly strategic allocation techniques has a positive impact on the performance of Asset- Liability Management programmes. The programme includes research on the benefits of alternative investments, such as hedge funds, in long-term portfolio management. Particular attention is given to the institutional context of ALM and notably the integration of the impact of the IFRS standards and the Solvency II directive project. Edhec Risk and Asset Management Research Centre 21

Edhec Risk and Asset Management Advisory Board In a desire to guarantee that its research work is both relevant and operational, the Edhec Risk and Asset Management Research Centre has set up an advisory board chaired by Mr. Jean-François Lepetit, associate professor with Edhec and former president of the French regulatory authority, the COB (Commission des Opérations de Bourse). The board is made up of around twenty members, chosen according to their experience and their expertise in the financial domain and, more specifically, in asset management. The functions of the board are, on the one hand, to validate the objectives of the research programmes proposed by the management of the centre and, on the other, to evaluate the results of the research with a view to the impact that they could have on the practices of the asset management industry. The board will also be called on to give its opinion on the content of the projects that Edhec develops from the research of its asset management research centre (initial training, executive training, etc.). The board meets on a yearly basis during plenary sessions that allow current and future research centre developments to be reviewed. The board chairman may also, on certain subjects, form adhoc working groups that would be in charge of preparing or studying in greater detail themes that have been or will be brought up in the plenary session. Research for business In order to facilitate the dialogue between the academic and business worlds, the centre has recently undertaken four major initiatives: Opening of a web site that is entirely devoted to the activity of international research into asset management. www.edhec-risk.com is aimed at a public of professionals who wish to benefit from Edhec's analyses and expertise in the field of applied portfolio management research such as detailed summaries, from a business perspective, of the latest academic research on risk and asset allocation as well as the latest industry news assessed in the light of the results of the Edhec research programme. www.edhec-risk.com is also the official site for the Edhec Indices. Launch of Edhec-Risk Advisory, the consulting arm of the research centre focusing on risk management issues within the buy-side industry, and offering a wide range of services aimed at supporting fund managers and their service providers in the fields of operational risk, best execution, structured products, alternative investment due diligence and risk management system implementation. Launch of Edhec Investment Research, in order to support institutional investors and asset managers in implementing the results of the Edhec Risk and Asset Management Research Centre s research. Edhec Investment Research proposes asset allocation services in the context of a coresatellite approach encompassing alternative investments. Launch of Edhec Alternative Investment Education, which is the exclusive official CAIA association course provider for Europe. The team The aim of the Edhec Risk and Asset Management Research Centre is to become the leading European centre of research into asset management in the coming years. To that end, Edhec has invested significantly to give the centre an international research team made up of both professors and permanent researchers, with whom professionals are affiliated in the capacity of research associates. To date, the Edhec Risk and Asset Management Research Centre has more than 28 members: 15 permanent members and 13 associates that are operating in firms that are reputed for their proficiency in asset management. This team is managed by Professor Noël Amenc, who has considerable experience in asset management as both an academic and a professional. 22 Edhec Risk and Asset Management Research Centre

Edhec Risk and Asset Management Research Centre 393-400 Promenade des Anglais BP 3116 06202 Nice Cedex 3 France Tel. +33 (0)4 93 18 78 24 Fax +33 (0)4 93 18 78 40 research@edhec-risk.com www.edhec-risk.com