A Performance Analysis of the Hedge Funds Industry

8/9/2019 A Performance Analysis of the Hedge Funds Industry

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1. INTRODUCTION

There is no exact definition to the term Hedge Fund; it is perhaps undefined in any

securities law. There is neither an industry wide definition nor a universal meaning for

Hedge Fund. For general purposes, hedge funds, including fund of funds, can beconsidered as unregistered private investment partnerships, funds or pools that may invest

and trade in many different markets, strategies and instruments (including securities, non-

securities and derivatives) and are not subject to the same regulatory requirements as

mutual funds.

The first hedge fund was set up by Alfred W. Jones in 1949, though the term did not gain

popularity until 1960s. Jones wanted to eliminate a part of the market risk involved in

holding long stock positions by short-selling other stocks. He thereby shifted most of hisexposure from market timing to stock picking. Jones was the first to use short sales,

leverage and incentive fees in combination. In 1952, he converted his general partnership

fund into a limited partnership investing with several independent portfolio managers and

created the first multi-manager hedge fund. In the mid 1950's other funds started using

the short-selling of shares, although for the majority of these funds the hedging of market

risk was not central to their investment strategy.

In 1966, an article in Fortune magazine about a "hedge fund" run by a certain A. W.

Jones shocked the investment community. During the 10-year period from 1955-1965

Jones' fund returned 670 percent. Apparently, the fund had outperformed all the mutual

funds of its time, even after accounting for a hefty 20% incentive fee. The first rush into

hedge funds followed and the number of hedge funds increased from a handful to over a

hundred within a few years.

Thus has started the hedge fund industry, which though initially faced a lot of problems

with inexperienced newcomers gradually picked up its admiration and is now considered

to be the fastest growing segment of the financial markets.

The industry with an average fund size of US $ 125 mm and growing at an astounding

growth rate not just while reaching out to new customer segments institutions, pension


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funds and endowments has now attracted even the retail investor through its fund of

funds. But there are also claims that with the increase in the craze for the hedge funds, a

lot of new managers have come in with insufficient experience and are misusing the term

hedge funds.

How true is this? Is the outstanding return generating ability of the hedge funds really

gone down? Is it the trend that everyone needs to catch up to or the beginning of the end

of a legend? There arises the necessity to analyse the industry performance and to

understand how the industry had performed and is performing in the current times.

The project employs sophisticated techniques, the results of a lot of academic works, to

analyse the performance of the hedge funds industry in an efficient manner, escaping any

underlying biases, under the constraints of limited resources of time, information and of

course the ability of comprehension.

The next section deals with understanding the growth of the hedge fund industry and the

probable reasons for the same. Section 3 explains the process and path behind the

performance analysis. Section 4 details the performance analysis using different

observations. Section 5 concludes the report talking of the worries about the future. Four

appendixes attached help understand some background information about the hedgefunds, the indexes involved in the analysis and the mathematics behind skewness and

kurtosis.


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2. GROWTH OF HEDGE FUNDS

The term hedge funds first came into use in the 1950s to describe any investment fund

that used incentive fees, short selling, and leverage. Since then, the industry of hedge

funds kept growing. Over time, hedge funds began to diversify their investment portfoliosto include other financial instruments and engage in a wider variety of investment

strategies. Today, in addition to trading equities, hedge funds may trade fixed income

securities, convertible securities, currencies, exchange traded futures, over the counter

derivatives, futures contracts, commodity options and other non-securities investments.

However, hedge funds today may or may not utilize the hedging and arbitrage strategies

that hedge funds historically employed, and many engage in relatively traditional, long

only equity strategies. This must make it clear as to why most of the discussions abouthedge funds, including this, start with the statement There is no exact definition to the

term Hedge Fund *.

2.1. Number of Hedge Funds and Total Assets

As the hedge fund

industry remains non-

regulated, it is very

difficult to quantify

exactly the size of the

industry. But there are a

few industry information

sources that help the

market estimate the

statistics of the industry.

One such source helps

understand the evolution. Figure 2.1: Growth in the Hedge Fund Assets from Jan 50 to Jan 04

* For more details about Hedge Funds refer Appendix A.

Hedge Fund Assets(US $Billions)

$0.50 $1.00 $3.00 $2.00$20.00 $35.00

$76.00$130.00

$221.00

$324.00

$408.00

$546.00$592.00

$795.00

$0.00

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

$700.00

$800.00

$900.00

Jan-50 Jan-60 Jan-71 Jan-74 Jan-87 Jan-92 Jan-95 Jan -97 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04


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Very clearly, from the above graph, hedge funds have attracted significant capital over

the last decade, apparently triggered by successful track records. The global hedge funds

volume has increased at an astonishing growth rate, from US $20 billion in 1987 to US

$795 billion in 2004. Estimates of new assets flowing into hedge funds exceed US $25

billion on average for the last few years. By 2008, hedge fund assets have been predicted

to reach the US $ 2 trillion mark. This makes hedge funds as the sector showing the most

growth in the entire financial services arena.

The global hedge fund volume

accounts for about 1% of the

combined global equity and

bond market. The number of

hedge funds has also increased

rapidly from 100 to about 7000

between 1987 and 2004.

Figure 2.2: Growth in the Number of Hedge Funds from Jan 50 to Jan 04

Number of Hedge Funds

1 30 140 30 100

880

2080

3000

3500

4000

4800

55005700

7000

0

1000

2000

3000

4000

5000

6000

7000

8000

Jan-50 Jan-60 Jan-71 Jan-74 Jan-87 Jan-92 Jan-95 Jan-97 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04


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2.2. Prospective Markets for More Growth

In Europe the overall hedge fund volume is still small with about US $ 80 billion in 2003,

which accounts for about 11% of the global hedge fund volume. The number of hedge

funds in Europe is about 600. Within Europe, hedge funds have become particularly

popular in France and Switzerland where already 35% and 30% of all institutional

investors have allocated funds into hedge funds. In 2003, Italys hedge fund industry

nearly tripled in size as assets grew from Euro 2.2 billion to Euro 6.2 billion. Germany is

at the lower end with only 7% of the institutional investors using hedge funds. But the

Investment Modernization Act, may well trigger rising interest from German investors.

Overall, hedge fund assets are estimated to increase ten fold in Europe over the next 10

years.

The acceptance of hedge funds seems to be growing through out Europe, as investors

have sought alternatives that are perceived as less risky during the last three years equity

bear market. This trend is also evident in Asia, where hedge funds are starting to take off.

According to AsiaHedge magazine, some 150 hedge funds operate in Asia, till year 2002

which together managed assets estimated at around US $ 15 billion. In Japan, too hedge

funds are becoming the focus of more attention. Recently, Japans Government Pension

Fund one of the worlds largest pension fund with US $ 300 billion has announced plans

to start allocating money to hedge funds. Industry participants believe that Asia could be

the next region of growth for the hedge fund industry. The potential of Asian hedge funds

is well supported by fundamentals. From an investment perspective, the volatility in the

Asian markets in recent years has allowed long-short and other strategic players to

outperform regional indices. The relative inefficiency of the regional markets also

presents arbitrage opportunities from a demand stand point US and European investors

are expected to turn to alternatives in Asia as capacity in their home markets diminish.

Further, the improving economic climate in South East Asia should help foreign fund

managers and investors to refocus their attention on the region. Overall, hedge funds look

set to play a larger role in Asia.


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2.3. Probable Reasons for Growth

There are a number of factors behind the rising demand for hedge funds. While high net

worth individuals remain the main source of capital, hedge funds are becoming more

popular among institutional and retail investors. Funds of funds (hedge funds) and other hedge fund-linked products are increasingly being marketed to the retail investors in

some jurisdictions. Public funds, endowments, and corporate sponsors have all increased

their allocations to hedge funds within the context of an increased allocation towards

alternative investments more generally. This move towards increased investments in real

estate/private equity/hedge funds (alternative investments) is driven by the need for a

higher return to compensate for the expected lower returns from more conventional

investment strategies focused on US bonds and equities.

The unprecedented bull run in the US equity markets during the 1990s swelled

investment portfolios this lead both fund managers and investors to become more keenly

aware of the need for diversification. Hedge funds are seen as a natural hedge for

controlling downside risk because they employ exotic investments strategies believed to

generate returns that are uncorrelated to asset classes.

Until recently, the bursting of the technology and telecommunications bubbles, the waveof scandals that hit corporate America and the uncertainties in the US economy have lead

to a general decline in the stock markets worldwide. This in turn provided fresh impetus

for hedge funds as investors searched for absolute returns. The growing demand for

hedge fund products has brought changes on the supply side of the market. The prospect

of untold riches has spurred on many former fund managers and proprietary trades to

strike out on their own and set up new hedge funds. With hedge funds entering the main

stream and becoming respectable, an increasing number of banks, insurance companies,

pension funds, are investing in them. There is also a clear desire among this investor base

to be more focused on absolute-return strategies rather than relative return. Given the

current level of allocations most of these large long-term investors have moved towards

alternative investments, and their professed long-term target allocation, the flow of funds

to these asset classes will remain strong.


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3. BEHIND THE PERFORMANCE ANALYSIS

3.1.Data

One of the most common ways to comprehend and appreciate the performance of

something is to consider its historical data. As our subject of concentration here is the

hedge fund industry as a whole, it would be brilliant if the historical data involves all the

hedge funds in the industry. But unfortunately that is not possible because of lack of easy

availability of all the data. Since hedge funds do not register with SEC their actual data

cannot be independently followed and thus the only way one can expect the data is

through self-reporting by the hedge fund which would further lead to non-uniformity in

the database.

These hedge funds though, for varied reasons, report their performance to many

information sources, which disseminate the same to the market, helping a big lot of

investors and researchers. Most of these sources also calculate indexes to indicate the

movement of the industry as a whole. Thus, for our purpose, these hedge fund indexes are

chosen as the most logical way to understand the industry performance.

Seven such hedge fund indexes have been obtained from their respective websites. They

include Altvest, CSFB/Tremont, EACM-100 Onshore, HFR, Hennessee, MSCI Hedgeand VAN *. But the very fact that there are so many hedge fund indexes leaves us with the

problem of which to use. Added to that, many research reports indicate that these hedge

fund indexes have biases, making them, individually, unreliable.

* For more details about Hedge Fund Indexes refer Appendix B.


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3.2.Biases in Hedge Fund Indexes

The hedge fund indexes have been set up to provide the rigorous data and analytics that

both managers and investors increasingly demand for measuring performance and risk in

this rapidly growing asset class. However, there are inherent problems in compiling a benchmark for the hedge fund industry, specifically including the presence of various

biases in the databases. There are three main sources of difference between the

performance of hedge funds in the database and the performance of hedge funds in the

population (see Fung and Hsieh (2001a)).

Survivorship bias: This occurs when unsuccessful managers leave the industry,

and their successful counterparts remain, leading to successful managers only

being counted in the database. The inherent problem is that a database over-

estimates the true returns in a strategy, because it only contains the returns of

those that were successful, or at least of those that are currently in existence.

Selection bias: This occurs if the hedge funds in the database are not

representative of those in the universe. Information on hedge funds is not easily

available. This is because hedge funds are often offered as a means of private

placement, and no obligation of disclosure is imposed in the US. As a result,

database vendors collect information on those hedge fund managers who

cooperate only.Besides, when a hedge fund enters a vendor database, the fund history is generally

backfilled. This gives rise to an instant history bias (Park (1995)). Since we

expect hedge funds with good records to report their performance to data vendors,

this may result in upwardly biased estimates of returns for newly introduced funds

Researches indicate that these biases are not insignificant and cannot be neglected. Fung

and Hsieh (2000), using the TASS database, find that the surviving portfolio had an

average return of 13.2 % from 1994 to 1998, while the observable portfolio had an

average return of 10.2 % during this time, from which, there is a 3% survivorship bias per

year for hedge funds (a similar number is obtained in Park et al. (1999)). The attrition

rate, defined as the percentage of dead funds in the total number of funds has been

reported by Agarwal and Naik (2000b) as 3.62%, 2.10% and 2.22% using quarterly, half


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yearly and yearly returns, which is consistent with an average annual attrition rate of

2.17% in the HFR database reported by Liang (1999) for 1993-97. These attrition rates

are much lower than the annual attrition rate of about 14% for offshore hedge funds in

1987-96 reported by Brown, Goetzmann and Ibbotson (1999) and 8.3% in the TASS

database in 1994-98 as reported by Liang (1999). Overall, it is probably a safe

assumption to consider that these biases account for a total approaching at least 4.5%

annually (see Park, Brown and Goetzmann (1999) and Fung and Hsieh (2000))

Figure 3.1: Survivorship, Selection Biases in Hedge Fund Returns


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3.3.Pure Style Index

As the above researches indicate, in the presence of many different competing indexes,

one may be at a loss to decide which one to use for benchmarking the performance of active or passive managers. There are essentially two possible approaches to the problem.

One approach involves carefully studying the methods and data used by each index

provider, and coming up with a qualitative assessment of which is doing the best job. The

problem is that there is no clear and definitive judgement that one can make on the

subject. All existing indexes have both advantages and drawbacks.

Second approach. Given that it is impossible to come up with an objective judgement on

what is the best existing index, a natural idea consists of using some combination of

competing indexes, a pure style index, to reach a better understanding of what the

common information would be. In other words, searching for some notion of

intersection of competing indexes.

One straightforward method for obtaining a composite index based on various competing

indexes would involve computing an equally weighted portfolio of all competing indexes.

This would obviously provide investors with a convenient one-dimensional summary of the contrasted information contained in competing indexes. In particular, because

competing hedge fund indexes are based on different sets of hedge funds, the resulting

portfolio of indexes would be more exhaustive than any of the competing indexes it is

extracted from. For our purposes, this method has been considered efficient.

The pure style index thus calculated then requires some base index to understand and

compare the performance with. As hedge funds are considered alternative investments

(non-traditional investment with potential economic value), it has been considered logicalto compare the index with a more traditional investment equity. In the process, it can

also be understood if the high fees charged by the hedge funds are worth it.

The equity market provides the investor base once again with a range of indexes, creating

the problem of which to use. But unlike earlier, we do not calculate an index that


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represents all the market indexes. Instead the pure style average index is compared to the

different market indexes individually. The equity market indexes thus chosen and what

they specifically represent are shown in the table below.

Equity Market Index Represents

Dow Jones Industrial Average (DJIA) 30 large frequently traded stocks

MSCI Europe, Australasia and Far East21 developed markets outside North

America

Standard & Poors (S&P) 500Top 500 US corporations by market

capitalisation

Wilshire 5000Entire US stock market all public

companies

Russell Midcap Mid-cap segment of US equity market

Russell 2000 Small-cap segment of US equity market

Russell Microcap Microcap segment of US equity market

Table 3.1: Market Indexes considered in the Analysis and their respective segments

As can be seen from the above table, the market indexes * have been carefully chosen to

help compare the hedge fund universe with different segments from large-cap to micro-

cap and ultimately the major equity markets.

* For more details about Market Indexes refer Appendix C.


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3.4.Methodology

For the hedge fund indexes, the problem of which to use was given a solution of

calculating a pure style index to rectify the biases discussed earlier. The pure style index

has been created in its simplest form average. Six different hedge fund indexes Altvest, CSFB/Tremont, EACM-100 Onshore, HFR, Hennessee and VAN involving

monthly returns from January 1996 to December 2005 have been used to calculate the

pure style average index.

Sharpe Ratio, the most widely used traditional risk-adjusted performance measure, has

been considered as to compare the performance of the pure style index against the broad

equity market indexes. The Sharpe ratio can be defined as a risk-adjusted measure

developed by William F. Sharpe, calculated using standard deviation and excess return todetermine reward per unit of risk. The higher the Sharpe ratio, the better the fund's

historical risk-adjusted performance.

The above formula gives monthly Sharpe ratio, which can be annualized by multiplying

the result with square root of 12.

The risk-free return for our purposes has been considered as the return of 90 day T-bill

return.

This Sharpe ratio has many desirable properties. However it is not flawless. It is leverage

invariant; it does not account for correlations; nor can it handle iceberg risks lurking inthe higher moments. Worse yet, it can be gamed by truncating the right tail of the

returns distribution at the expense of a fat left tail (the periodic crashes). It has also been

researched and proved that high Sharpe ratios in hedge funds often represent a trade-off

for higher moment risk.


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One line of thought is to salvage the Sharpe ratios relevance while retaining the familiar

form by replacing standard deviation in the denominator with an enhanced risk measure

such as VaR.

This is parametric VaR at 99% confidence level, which assumes normality of the

distribution. To remove this assumption that constrains to normality, a modification of

the above, Cornish Fisher VaR, can be used. This modified VaR includes the impact of

the skewness and kurtosis.

Where

Where (1- ) is the confidence level, z( ) the critical value under normality, S is

skewness, and K is excess kurtosis *.

The above VaR has been used in the denominator to calculate the enhanced Sharpe Ratio.

This enhanced Sharpe ratio has been used as the final risk adjusted performance measure

to compare the pure style index against the equity market indexes.

* For more details about Skewness and Kurtosis refer Appendix D.


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4. PERFORMANCE ANALYSIS

4.1. Raw Returns

The figure below compares the growth of US $1 invested in January 1996 in pure style

average (PSA) index and that invested in developed markets index (MSCI EAFE), 500

large corporations index (S&P 500) and the small-cap index (Russell 2000) of the US

equity market.

Growth of $1 invested in Jan 1996

0

0.5

1

1.5

2

2.5

3

3.5

1 9 9 5

1 9 9 6

1 9 9 6

1 9 9 7

1 9 9 7

1 9 9 8

1 9 9 8

1 9 9 9

1 9 9 9

2 0 0 0

2 0 0 0

2 0 0 1

2 0 0 1

2 0 0 2

2 0 0 2

2 0 0 3

2 0 0 3

2 0 0 4

2 0 0 4

2 0 0 5

2 0 0 5

Pure Style AverageMSCI EAFE

S&P 500Russell 2000

Figure 4.1: Comparison of Cumulative Returns of PSA from 1996 to 2005 with those of MSCI EAFE, S&P 500 and Russell 2000

One can observe that the PSA and the Russell 2000 outperformed the other two (MSCI

EAFE and S&P 500) from the beginning. The PSA and Russell 2000 grow on quite

similar lines till somewhere in the beginning of 1998, when Russell 2000 loses its

momentum leaving the PSA to lead. Major event that had happened during this time and

that can be expected to have caused the impact is the collapse of a huge hedge fund

LTCM. Since then the PSA had outperformed the other three. The MSCI EAFE, S&P

500 and the Russell 2000 grow the initial investment of $1 in 1996 to $2.5 in 2005; the

PSA grows it to $3.


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The figure below compares US $1 invested in January 1996 in the PSA to the traditional,

favorite index to many, involving 30 large and frequently traded stocks (DJIA) and a very

broad market index, which is often considered to represent the whole of US equity

market index.

Growth of $1 Invested in Jan 1996

0

0.5

1

1.5

2

2.5

3

3.5

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 7

1 9 9 8

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 0

2 0 0 1

2 0 0 1

2 0 0 2

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 4

2 0 0 5

2 0 0 5

Pure Style Average

DJIA

Wilshire 5000

Figure 4.2: Comparison of Cumulative Returns of PSA from 1996 to 2005 with those of DJIA and Wilshire 5000

PSA had initially faced problems in outperforming the market indexes DJIA and

Wilshire 5000. The DJIA and the Wilshire 5000 both outperformed the PSA and

appeared to move at a better angle to the PSA. But something happened; sometime

during third quarter of 2000 that has changed the scenario. The market indexes fell. A

major market event that had happened during this period is the crash of the dot-com

bubble, which could have triggered the above consequences. The $1 invested in DJIA

and Wilshire 5000 reached a high of $2.35 and $2.24 respectively during 1999-2000 and

finally by December 2005 made it to just above $2 whereas the PSA reached the $3

mark.


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In the next graph the growth of US $1 invested in PSA is compared to that invested in the

mid-cap segment index of the US equity markets.

Growth of $1 invested in Jan 1996

0

0.5

1

1.5

2

2.5

3

3.5

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 7

1 9 9 8

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 0

2 0 0 1

2 0 0 1

2 0 0 2

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 4

2 0 0 5

2 0 0 5

Pure Style AverageRussell Midcap

Figure 4.3: Comparison of Cumulative Returns of PSA from 1996 to 2005 with those of Russell Midcap

The story of the growth of the investment remains the same as that discussed above till

the first quarter of 2003. But after that, unlike the DJIA and the Wilshire 5000, the

Russell Midcap picks up momentum, reaches the PSA and crosses it over to finish with

some lead. By the end of 2005, the US $1 invested in the PSA reached the $3 mark

whereas that invested in the Russell Midcap reached $3.24.

For the reasons of availability of data, the PSA is compared to Russell Microcap by

investing US $1 in July 2000. The graph below shows the path of the PSA and that of the

micro-cap segment index of the US equity market.


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Growth of $1 Invested in July 2000

00.2

0.4

0.6

0.8

1

1.2

1.41.6

1.8

2 0 0 0

2 0 0 0

2 0 0 1

2 0 0 1

2 0 0 1

2 0 0 2

2 0 0 2

2 0 0 2

2 0 0 3

2 0 0 3

2 0 0 3

2 0 0 4

2 0 0 4

2 0 0 4

2 0 0 5

2 0 0 5

2 0 0 5

Pure Style Average

Russell Microcap

Figure 4.4: Comparison of Cumulative Returns of PSA from 2000 to 2005 with those of Russell Microcap

The growth of $1 investment in the PSA was very dull till the beginning of the third

quarter of 2003 while the Microcap index most of the time projected negative returns

during the same period. Growing from there, by the end of 2003, the Microcap index

crosses the PSA and continues to outperform till the end of the period of consideration,

December 2005. By the end, the $1 invested in the PSA returns $1.45 while that invested

in Russell Microcap index returns $1.66.


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4.2. Correlations

The table below shows the correlations between the PSA and the market indexes.

Index Correlation with PSADJIA 0.57MSCI EAFE 0.66S&P 500 -0.03Wilshire 5000 0.74Russell Midcap 0.79Russell 2000 0.82Russell Microcap 0.88

Table 4.1: Market Indexes and respective correlation coefficients with PSA

The performance graphs we discussed earlier showed how the markets swung. But the

PSA showed very little fluctuations with respect to the market indexes. The same is

reflected in the low correlations in the above table with the large cap indexes DJIA,

MSCI EAFE and S&P 500. In fact the PSA is negatively correlated with the S&P 500.

This clearly confirms with the researches that indicate the ability of hedge funds to

provide diversification benefits to traditional equity investment.

In fact this low correlation between hedge funds' performance and the market's ups and

downs is the main reason why such funds are valued as alternate investment vehicles.

They essentially exploit market inefficiencies, using long or short positions to offsetmarket risks

Interesting part of these statistics is the high correlations with the Russells small-cap,

mid-cap and micro-cap indexes. Researches indicate that the vast majority of equity

hedge funds remain focused on the large capitalization end of the market, while the small

and micro cap segments, particularly the growth sectors of those segments, have been

largely ignored. As of August 2003, less than 2% of the active hedge funds tracked by

HedgeFund.net were categorized as small/micro cap funds. Considering this to be the

case, the high correlations with the small, mid and micro-cap indexes must indicate that

most of the hedge funds though do not fully focus on these segments, their positions

definitely have some exposure to these segments and effectively hedged too.


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4.3. Volatility

Observe the performance graphs above. In all of them, the market indexes wobbled, in

fact staggered at a few instances in their path to December 2005. The PSA though,

appeared calm and grew its investment quite swiftly. This indicates that the marketindexes when compared to the PSA are highly volatile. The following table speaks the

same in a different language.

Index Annual Standard DeviationDJIA 15.82 %MSCI EAFE 14.85 %S&P 500 14.92 %Wilshire 5000 15.87 %Russell Midcap 16.27 %Russell 2000 20.17 %Russell Microcap 20.83 %Pure Style Average (PSA) 6.53 %

Table 4.2: Indexes and respective annualized standard deviations

The Annual Standard Deviations above talk in real harsh words. Even the Russell Midcap

and the Russell Microcap indexes, the only two that outperformed the PSA, have been

destroyed when it came to comparing the standard deviation. But the standard deviations

in themselves cannot be used as a basis of performance comparison.

Standard Deviation relies on the

assumption that the return distribution is

symmetric around its mean and implies

that the sensitivity of the investor is the

same on the upside as on the downside.

The problem is that hedge fund returns do

not follow the symmetrical return paths

implied by traditional volatility. Instead,

hedge fund returns tend to be skewed. Figure 4.5: Graph showing an example of a fat tail (negative skewness)

Specifically, they tend to be negatively skewed, which means they bear the dreaded "fat

tails", which are mostly characterized by positive returns but a few cases of extreme

losses.


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4.4 Sharpe Ratios

For the reasons discussed above, to salvage the problem of fat tails, academic studies

propose that measures of downside risk can be more useful than volatility or Sharpe ratio

as a scale of performance.

In order to take the asymmetry in the return distribution into account, the use of downside

deviation as risk measure has been frequently advocated (see e.g. Sortino and Price

(1994), Bacmann and Pache (2003)). In such a context, the Value-at-Risk, designed to

capture the maximum loss over a target time horizon with a given degree of confidence is

far better suited. VaR has been getting a very wide acceptance throughout the financial

community as it translates a complex risk notion into a simple and synthetic monetary

amount.

Considering the above reasons and as already discussed earlier in methodology,

modified VaR has been used to calculate an enhanced Sharpe ratio for measuring the

performance of the PSA.

The table below indicates the enhanced Sharpe ratios of the PSA and the market indexes.

Index Enhanced Sharpe RatioDJIA 0.15MSCI EAFE 0.03S&P 500 0.22Wilshire 5000 0.17Russell Midcap 0.34Russell 2000 0.18Russell Microcap 0.20Pure Style Average (PSA) 0.70

Table 4.3: Indexes and respective Sharpe Ratios, enhanced using VaR

Higher the Sharpe ratio, the better it is. It is common to read that in absolute terms a

Sharpe ratio greater than 1 is good. But one cannot judge the performance of an index,

which in itself constitutes many funds in absolute terms. Following the same in using the

table above, the PSA shows an enhanced Sharpe ratio of 0.70 whereas the market indexes

average an enhanced Sharpe ratio of 0.19. This clearly indicates that the PSA, in terms of

the enhanced Sharpe ratio, has outperformed the other market indexes by a large margin.


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More interesting to observe is how the Russell Midcap stands out of the crowd. But the

PSA is still far from it.

In the calculation of the Sharpe ratio above, the data made use of starts from January

1996. This means, any decision based on just the ratios above would take into accountany event that had happened ten years back too. In other words the Sharpe ratios

calculated above do not present us with enough information to understand the current

performance of the hedge fund industry.

For this reason, the time period of ten years has been divided into four groups 1996-

1997, 1998-1999, 2000-2002 and 2003-2005. The groups have been formed as to help

understand the performance of the PSA with major events in the US stock market during

that time. The period of 1996-1997 would represent a period with high interest rates,

1998-1999 would represent how the great disaster of the hedge fund industry collapse

of the Long Term Capital Management affected the enhanced Sharpe ratio of the PSA,

2000-2002 is the period following burst of the dot-com bubble that changed the opinions

of so many bulls, and finally 2003-2005 represents the most recent period.

The table below indicates the enhanced Sharpe ratios calculated separately during the

four periods of consideration for the PSA and the equity market indexes.

Time

Period

DJIA MSCI

EAFE

S&P

500

Wilshire

5000

Russell

Midcap

Russell

2000

PSA

1996-1997 1.12 -0.09 1.35 1.11 0.95 0.52 2.32

1998-1999 0.63 0.74 1.56 1.33 0.43 0.21 0.58

2000-2002 -0.22 -0.54 -0.32 -0.35 -0.11 -0.11 0.14

2003-2005 0.24 0.75 0.50 0.52 0.95 0.64 1.50Table 4.4: Enhanced Sharpe Ratios of the Indexes during the four sub-periods

In the high interest rates period (1996-1997), most of the market indexes performed well.

MSCI EAFE and the small cap segment index, Russell 2000 are the ones that had


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received the beating compared to the rest of the market indexes. But still, the PSA beats

the market by a huge margin, projecting an astonishing Sharpe ratio.

During the period when one of the biggest hedge funds in America, Long Term Capital

Management, collapsed, (1998-1999), the pride of PSAs outstanding performances gotshattered. Except the small and mid-cap segment indexes, the rest four outperformed the

PSA when it projects a mild Sharpe ratio of 0.58.

The next period: 2000-2002. The bull market run by the dot-coms crashed. All the market

indexes projected negative Sharpe ratios. In the midst of the markets tears though, the

PSA stood tall. Though the Sharpe ratio was not absolutely astonishing, the very fact that

it projected a positive ratio when the whole market collapsed gained the hedge funds their

fame back. The fame that the hedge funds can perform better irrespective of the market

direction.

The PSA maintains its respect high in the recent period (2003-2005). It continues to beat

the market indexes by a considerable margin. Interesting to observe: sudden growth in the

Sharpe ratio of the small-cap index.

The following graph might help better understand the movement of the enhanced Sharpe

ratio of the indexes with time.


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4.5. Correlations with Time

The following table indicates how the correlation between the PSA and the market

indexes changed during the four periods considered.

Time Period DJIA MSCIEAFE

S&P500

Wilshire5000

RussellMidcap

Russell2000

1996-1997 0.66 0.55 0.75 0.82 0.83 0.741998-1999 0.73 0.68 0.75 0.81 0.81 0.862000-2002 0.37 0.68 0.55 0.64 0.77 0.862003-2005 0.68 0.83 0.76 0.79 0.83 0.80

Table 4.5: Correlations of the Market Indexes with the PSA during the four sub-periods

One can observe that the correlation between the PSA and the small and mid-cap segment

indexes have been consistently high. It was highly correlated with the Russell indexes

when the market on the whole had destroyed the PSA (1998-1999) and it was highly

correlated even when the PSA gains back its fame (2000-2002).

The correlation of the PSA with the MSCI EAFE, which represents developed markets

other than, US had been slowly increasing during 1996-2002 and had suddenly jumped to

high levels in the most recent period (2003-2005). This might indicate that the hedge

funds realized that the US markets have saturated and exploiting inefficiencies in

valuation has become difficult and thus moved to the other developed markets to gulp the

new potential.


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5. THE DECLINE

Although the PSA shows that the hedge fund industry as such is being successful in

outperforming the market indexes, one must also accept that the average returns

generating ability of a hedge fund has gone down with the growth in the number of hedgefunds.

There is a feeding frenzy currently under way in the world of alternative investments and

clients are paying up the higher fees for fear of being locked out from these funds at a

later date, if they actually survive and grow. One reason why the new boys are focusing

more on fees and lock-ups could be the difficulty all hedge funds are having in generating

adequate alpha (excess return) to ensure an adequate payout.

In a study done by Morgan Stanley on the excess returns generated by hedge funds over

the last decade, this trend of declining returns was very apparent. In the study they

defined excess returns as the return of the Hedge Fund research composite over one

month LIBOR (a proxy for cash returns). In the 1995-97 period, excess returns were 14

per cent; and as the research indicates, these returns have consistently declined dropping

to as low as 5 per cent in 2001-03 and have dropped further since.

The beauty of the hedge fund business and the reason why the upward drift in fee

structure is even more surprising is the ease of entry of new players into the game. The

average long short hedge fund needs only about six back office staff per billion dollars,

while a global macro fund needs about 11 people for a fund of similar size (Morgan

Stanley survey). The typical long short US equity manager has only nine investment

professionals and three in the back office. These funds are also not really regulated and

have very limited disclosure requirements, if any. The start-up costs of these vehicles are

also minimal and most funds will be able to break even at sub $100 million in assetsunder management.

Hedge funds are clearly here to stay, and continue to attract the best talent because of

their payout structures; however, their ability to continue to command a premium fee


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structure will eventually be limited by their ability to differentiate themselves from their

long-only counterparts.

Researches (Fung, Hsieh, Naik, and Ramadorai, 2005) also indicate that there is an

apparent mismatch between the supply and demand for alpha. On the one hand, thesupply of alpha appears to be drying up. On the other, capital appears to be seeking alpha.

This could presage changes in the organization of the hedge fund industry. Contracts in

the hedge fund industry are currently structured to reward managers for generating

returns above pre-specified fixed benchmarks. Conditioning incentives on risk-adjusted

performance may be a better way to go. In other words, a fund manager must be provided

with his incentive fees, which instead of basing on total returns must be based on the

generated alpha (excess returns). If such a scenario develops in the hedge fund industry,

the new players entering the industry would be more careful in applying sophisticated

strategies, generating better returns.


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6. CONCLUSIONS

Hedge funds have attracted significant capital over the last decade triggered by successful

track records. The number of hedge funds has also increased rapidly from 100 to about

7000 between 1987 and 2004. The capital inflows into the industry have got the extra push with institutions like pension funds and endowments showing interest in hedge

funds.

Most of the growth in the hedge funds is concentrated in just US market. In recent times,

though, the acceptance of hedge funds seems to be growing through out other markets

Europe and Asia with Japan growing as the new potentially big center.

The previously enjoyed by the high net worth individuals, hedge funds, are making their way to other segments of the market too - institutional and retail investors. Funds of

funds (hedge funds) and other hedge fund-linked products are increasingly being

marketed to the retail investors in some jurisdictions. Public funds, endowments, and

corporate sponsors have all increased their allocations to hedge funds within the context

of an increased allocation towards alternative investments more generally, in expectation

of higher returns.

The cumulative return performance of the Pure Style Hedge Fund Index calculated

through simple average using a returns data of 10 years (1996-2005) shows the hedge

fund industry to grow its investment at better rates than most of the market indexes. In

the more recent times, the Russells Midcap and Microcap indexes outperformed the Pure

Style Index.

In terms of Standard Deviation, the PSA had made itself a place at a high elevation, far

from the market indexes. The performance graphs indicate that the volatility of the hedgefunds on an average are quite low compared to the market indexes and thus can be

considered to as living up to their name Hedge Funds.


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The enhanced Sharpe ratio calculated using the Cornish-Fisher VaR indicates superior

performance by the Pure Style Average and thus the hedge fund industry on an average.

The PSA outperforms the market indexes in the overall period of consideration (10 years)

and also thrice in four sub-divided periods.

Correlation between the PSA and the small and mid-cap segment indexes has been

consistently high during the sub-divided periods. The slow and sudden rises of the

correlation between the pure style index and the MSCI EAFE indicates that the hedge

funds realized that the US markets have saturated and exploiting inefficiencies in

valuation has become difficult and thus moved to the other developed markets to gulp the

new potential.

Though the pure style index outperforms the market by a big margin, the absolute returns

of the hedge funds have got diluted with the increase in the number of new players. One

solution to this could be charging incentive fees based on alphas instead of the total

absolute returns. Also the alphas have to be measured with respect to a benchmark that

assumes similar risk profile.


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REFERENCES

Jeffrey P. James , Exploiting the Inefficiencies of The Small Cap Market Through HedgeFunds, AIMA Journal, December 2003.

GFS Induction Programme , Hedge Fund Strategies, M Allen, Aug 2004.

Martin Eling , Autocorrelation, Bias and Fat Tails Are Hedge Funds Really AttractiveInvestements? , Working Papers on Risk Management and Insurance No. 8, UniversitatSt. Gallen.

Alexander M. Ineichen , Hedge Funds: Bubble or New Paradigm? , Journal of GlobalFinancial Markets, Vol.2, No. 4, 21 November 2001.

The Presidents Working Group on Financial Markets, Hedge Funds, Leverage, and theLessons of Long-Term Capital Management, April 1999.

William Reichenstein, What Are You Really Getting When You Invest in a HedgeFund?, July 2004.

LJH Global Investments, Why Invest in Hedge Funds Anyway? , June 2001.

Investor Force , Hedge Fund Survey, January 2003.

Harry M Kat, Sa Lu , An Excursion into the Statistical Properties of Hedge Funds,ISMA Discussion Papers in Finance 2002-12, 1 May 2002.

Francis Koh, Winston T. H. Koh, and Melvyn Teo, Asian Hedge Funds: ReturnPersistence, Style, and Fund Characteristics, June 2003.

Standard & Poors, December Rally Adds to Hedge Fund Returns for 2005, 11 January2006.

Jean Francois Bacmann and Gregor Gawron, Fat Tail Risk in Portfolios of HedgeFunds and Traditional Investements, RMF Investment Group, January 2004.

Mark Chambers, Hedge Fund Indices, Man Investment Products, AIMA Journal,December 2002.

Thomas Della Casa and Mark Rechsteiner, Hedge Fund Indices, RMF Hedge FundResearch, December 2004.

Walter Gehin , Hedge Fund Returns: An Overview of Return-Based and Asset-BasedStyle Factors, January 2006.


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Roger W. Merritt, Fitch Ratings, and Ian C. Linnell, Hedge Funds: An Emerging Forcein the Global Credit Markets, 28 February 2006.

David Setters, Hedge Funds and Derivatives: A Maturing Relationship.

Francois-Serge Lhabitant , Hedge Funds Investing: A Quantitative Look Inside theBlack Box, August 2001.

Staff Report to the United States Securities and Exchange Commission , Implications of Growth of Hedge Funds, September 2003.

Eurekahedge , Key Trends in Asian Hedge Funds, AIMA Journal, April 2004.

Beng Liang , On the Performance of Hedge Funds, May 1998.

Hedgequest, Searching for the perfect risk-adjusted performance measure, Summer

2005. Noel Amanc and Lionel Martellini , The Brave New World of Hedge Fund Indexes, 28January 2002.

Vadim Zlotnikov and Guillermo Maclean, Hedge Fund Industry Update One Year Later, The Song Remains the Same, Bernstein Research Call, 28 July 2004.

David Gordon , What Goes Up, Comes Down, 2002 AIC Conference.

Harry M. Kat , 10 Things That Investors Should Know About Hedge Funds, Spring2003.

CISDM Research Department , Benefits of Hedge Funds, 2005 Update.

Capocci Daniel , An Analysis of Hedge Fund Performance 1984-2000, November 2001.

Capocci Daniel, Comparitive Analysis of Hedge Fund Returns, January 2006.

William Fung, David A. Hsieh, Narayan Y. Naik and Tarun Ramadorai , Hedge Funds:Performance, Risk and Capital Formation, September 2005.

Kevin Dowd , Too Big To Fail? Long Term Capital Management and the FederalReserve, 23 September 1999.

Jenny Corbett and David Vines , East Asian Currency and Financial Crises: Lessonsfrom Vulnerability, Crisis and Collapse, Asia Pacific Press, 1999.

Lindsay I Smith , A Tutorial on Principal Components Analysis, 26 February 2002.


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http://www.globalfundanalysis.com/default.php?page=/article.php&&type=hedge_fund_info&id=21

http://www.fp.ed.gov/fp/attachments/interest/CurrentTreasuryBillPaperRates.doc

http://money.cnn.com/2005/07/01/markets/hedgefunds/index.htm http://money.cnn.com/2005/12/20/markets/hedge_funds/index.htm

http://www.miapavia.it/homes/ik2hlb/sr.htm

http://www.thehfa.org/Articles.cfm?CurrentPage=2

http://money.cnn.com/2006/01/31/markets/hedge_funds/index.htm


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APPENDIX A: ABCs of Hedge Funds

What is a Hedge Fund?

A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and

sell undervalued securities, trade options or bonds, and invest in almost any opportunity

in any market where it foresees impressive gains at reduced risk. Hedge fund strategies

vary enormously -- many hedge against downturns in the markets -- especially important

today with volatility and anticipation of corrections in overheated stock markets. The

primary aim of most hedge funds is to reduce volatility and risk while attempting to

preserve capital and deliver positive returns under all market conditions.

Key Characteristics of Hedge Funds

Hedge funds utilize a variety of financial instruments to reduce risk, enhance

returns and minimize the correlation with equity and bond markets. Many hedge

funds are flexible in their investment options (can use short selling, leverage,

derivatives such as puts, calls, options, futures, etc.).

Many hedge funds have the ability to deliver non-market correlated returns.

Many hedge funds have as an objective consistency of returns and capital

preservation rather than magnitude of returns.

Most hedge funds are managed by experienced investment professionals who are

generally disciplined and diligent.

Pension funds, endowments, insurance companies, private banks and high net

worth individuals and families invest in hedge funds to minimize overall portfolio

volatility and enhance returns.

Most hedge fund managers are highly specialized and trade only within their area

of expertise and competitive advantage.

Hedge funds benefit by heavily weighting hedge fund managers remuneration

towards performance incentives, thus attracting the best brains in the investment


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business. In addition, hedge fund managers usually have their own money

invested in their fund.

Facts About the Hedge Fund Industry

Includes a variety of investment strategies, some of which use leverage and

derivatives while others are more conservative and employ little or no leverage.

Many hedge fund strategies seek to reduce market risk specifically by shorting

equities or through the use of derivatives.

Many hedge fund strategies, particularly arbitrage strategies, are limited as to how

much capital they can successfully employ before returns diminish. As a result,

many successful hedge fund managers limit the amount of capital they willaccept.

Hedge fund managers are generally highly professional, disciplined and diligent.

Beyond the averages, there are some truly outstanding performers.

Investing in hedge funds tends to be favored by more sophisticated investors,

including many Swiss and other private banks, that have lived through, and

understand the consequences of, major stock market corrections.

An increasing number of endowments and pension funds allocate assets to hedge

funds.

Hedging Strategies

A wide range of hedging strategies are available to hedge funds. For example:

Selling short - selling shares without owning them, hoping to buy them back at a

future date at a lower price in the expectation that their price will drop.

Using arbitrage - seeking to exploit pricing inefficiencies between related

securities - for example, can be long convertible bonds and short the underlying

issuers equity.

Trading options or derivatives - contracts whose values are based on the

performance of any underlying financial asset, index or other investment.


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Investing in anticipation of a specific event - merger transaction, hostile takeover,

spin-off, exiting of bankruptcy proceedings, etc.

Investing in deeply discounted securities - of companies about to enter or exit

financial distress or bankruptcy, often below liquidation value.

Hedge Fund Styles

The predictability of future results shows a strong correlation with the volatility of each

strategy. Future performance of strategies with high volatility is far less predictable than

future performance from strategies experiencing low or moderate volatility.

Aggressive Growth: Invests in equities expected to experience acceleration in

growth of earnings per share. Generally high P/E ratios, low or no dividends; oftensmaller and micro cap stocks are expected to experience rapid growth. Includes sector

specialist funds such as technology, banking, or biotechnology. Hedges by shorting

equities where earnings disappointment is expected or by shorting stock indexes. Tends

to be "long-biased."

Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of

companies in or facing bankruptcy or reorganization. Profits from the market's lack of

understanding of the true value of the deeply discounted securities and because the

majority of institutional investors cannot own below investment grade securities. (This

selling pressure creates the deep discount.) Results generally not dependent on the

direction of the markets.

Expected Volatility: Low Moderate

Emerging Markets : Invests in equity or debt of emerging (less mature) marketsthat tend to have higher inflation and volatile growth. Short selling is not permitted in

many emerging markets, and, therefore, effective hedging is often not available, although

Brady debt can be partially hedged via U.S. Treasury futures and currency markets.

Expected Volatility: Very High


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Funds of Hedge Funds: Mix and match hedge funds and other pooled

investment vehicles. This blending of different strategies and asset classes aims to

provide a more stable long-term investment return than any of the individual funds.

Returns, risk, and volatility can be controlled by the mix of underlying strategies and

funds. Capital preservation is generally an important consideration. Volatility depends on

the mix and ratio of strategies employed.

Expected Volatility: Low - Moderate High

Income: Invests with primary focus on yield or current income rather than solely

on capital gains. May utilize leverage to buy bonds and sometimes fixed income

derivatives in order to profit from principal appreciation and interest income.Expected Volatility: Low

Macro: Aims to profit from changes in global economies, typically brought about

by shifts in government policy that impact interest rates, in turn affecting currency, stock,

and bond markets. Participates in all major markets -- equities, bonds, currencies and

commodities -- though not always at the same time. Uses leverage and derivatives to

accentuate the impact of market moves. Utilizes hedging, but the leveraged directional

investments tend to make the largest impact on performance.

Expected Volatility: Very High

Market Neutral - Arbitrage : Attempts to hedge out most market risk by taking

offsetting positions, often in different securities of the same issuer. For example, can be

long convertible bonds and short the underlying issuers equity. May also use futures to

hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to

both the equity and bond markets. These relative value strategies include fixed incomearbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund

arbitrage.

Expected Volatility : Low


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Market Neutral - Securities Hedging : Invests equally in long and short equity

portfolios generally in the same sectors of the market. Market risk is greatly reduced, but

effective stock analysis and stock picking is essential to obtaining meaningful results.

Leverage may be used to enhance returns. Usually low or no correlation with the market.

Sometimes uses market index futures to hedge out systematic (market) risk. Relative

benchmark index usually T-bills.

Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the

manager's view of the economic or market outlook. Portfolio emphasis may swing widely

between asset classes. Unpredictability of market movements and the difficulty of timing

entry and exit from markets add to the volatility of this strategy.Expected Volatility : High

Opportunistic: Investment theme changes from strategy to strategy as

opportunities arise to profit from events such as IPOs, sudden price changes often caused

by an interim earnings disappointment, hostile bids, and other event-driven opportunities.

May utilize several of these investing styles at a given time and is not restricted to any

particular investment approach or asset class.

Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing various

strategies simultaneously to realize short- and long-term gains. Other strategies may

include systems trading such as trend following and various diversified technical

strategies. This style of investing allows the manager to overweight or underweight

different strategies to best capitalize on current investment opportunities.

Expected Volatility : Variable

Short Selling : Sells securities short in anticipation of being able to re-buy them at

a future date at a lower price due to the manager's assessment of the overvaluation of the

securities, or the market, or in anticipation of earnings disappointments often due to


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accounting irregularities, new competition, change of management, etc. Often used as a

hedge to offset long-only portfolios and by those who feel the market is approaching a

bearish cycle. High risk.

Expected Volatility : Very High

Special Situations: Invests in event-driven situations such as mergers, hostile

takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase of

stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit

from the spread between the current market price and the ultimate purchase price of the

company. May also utilize derivatives to leverage returns and to hedge out interest rate

and/or market risk. Results generally not dependent on direction of market.

Expected Volatility: Moderate

Value: Invests in securities perceived to be selling at deep discounts to their

intrinsic or potential worth. Analysts may out of favor or under follow such securities.

Long-term holding, patience, and strong discipline are often required until the market

recognizes the ultimate value.

Expected Volatility: Low Moderate

Popular Misconception

The popular misconception is that all hedge funds are volatile -- that they all use global

macro strategies and place large directional bets on stocks, currencies, bonds,

commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge

funds are global macro funds. Most hedge funds use derivatives only for hedging or don't

use derivatives at all, and many use no leverage.


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Benefits of Hedge Funds

Many hedge fund strategies have the ability to generate positive returns in both

rising and falling equity and bond markets.

Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and

volatility and increases returns.

Huge variety of hedge fund investment styles many uncorrelated with each

other provides investors with a wide choice of hedge fund strategies to meet

their investment objectives.

Academic research proves hedge funds have higher returns and lower overall risk

than traditional investment funds.

Hedge funds provide an ideal long-term investment solution, eliminating the needto correctly time entry and exit from markets.

Adding hedge funds to an investment portfolio provides diversification not

otherwise available in traditional investing.

How does a hedge fund "hedge" against risk?

Some funds that are called hedge funds don't actually hedge against risk. Because the

term is applied to a wide range of alternative funds, it also encompasses funds that may

use high-risk strategies without hedging against risk of loss. For example, a global macro

strategy may speculate on changes in countries' economic policies that impact interest

rates, which impact all financial instruments, while using lots of leverage. The returns can

be high, but so can the losses, as the leveraged directional investments (which are not

hedged) tend to make the largest impact on performance. Most hedge funds, however, do

seek to hedge against risk in one way or another, making consistency and stability of

return, rather than magnitude, their key priority. (In fact, less than 5 percent of hedge

funds are global macro funds). Event-driven strategies, for example, such as investing in

distressed or special situations reduce risk by being uncorrelated to the markets. They

may buy interest-paying bonds or trade claims of companies undergoing reorganization,


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What is the difference between a hedge fund and a mutual fund?

There are five key distinctions:

1. Mutual funds are measured on relative performance - that is, their performance is

compared to a relevant index such as the S&P 500 Index or to other mutual funds in

their sector. Hedge funds are expected to deliver absolute returns - they attempt to

make profits under all circumstances, even when the relative indices are down.

2. Mutual funds are highly regulated, restricting the use of short selling and

derivatives. These regulations serve as handcuffs, making it more difficult to

outperform the market or to protect the assets of the fund in a downturn. Hedge

funds, on the other hand, are unregulated and therefore unrestricted - they allow for short selling and other strategies designed to accelerate performance or reduce

volatility. However, an informal restriction is generally imposed on all hedge fund

managers by professional investors who understand the different strategies and

typically invest in a particular fund because of the manager's expertise in a

particular investment strategy. These investors require and expect the hedge fund to

stay within its area of specialization and competence. Hence, one of the defining

characteristics of hedge funds is that they tend to be specialized, operating within a

given niche, specialty or industry that requires a particular expertise.

3. Mutual funds generally remunerate management based on a percent of assets

under management. Hedge funds always remunerate managers with performance-

related incentive fees as well as a fixed fee. Investing for absolute returns is more

demanding than simply seeking relative returns and requires greater skill,

knowledge, and talent. Not surprisingly, the incentive-based performance fees tend

to attract the most talented investment managers to the hedge fund industry.

4. Mutual funds are not able to effectively protect portfolios against declining

markets other than by going into cash or by shorting a limited amount of stock

index futures. Hedge funds, on the other hand, are often able to protect against


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declining markets by utilizing various hedging strategies. The strategies used, of

course, vary tremendously depending on the investment style and type of hedge

fund. But as a result of these hedging strategies, certain types of hedge funds are

able to generate positive returns even in declining markets.

5. The future performance of mutual funds is dependent on the direction of the

equity markets. It can be compared to putting a cork on the surface of the ocean -

the cork will go up and down with the waves. The future performance of many

hedge fund strategies tends to be highly predictable and not dependent on the

direction of the equity markets. It can be compared to a submarine traveling in an

almost straight line below the surface, not impacted by the effect of the waves.


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What is a Fund of Hedge Funds?

A diversified portfolio of generally uncorrelated hedge funds.

May be widely diversified, or sector or geographically focused.

Seeks to deliver more consistent returns than stock portfolios, mutual funds, unit

trusts or individual hedge funds.

Preferred investment of choice for many pension funds, endowments, insurance

companies, private banks and high-net-worth families and individuals.

Provides access to a broad range of investment styles, strategies and hedge fund

managers for one easy-to-administer investment.

Provides more predictable returns than traditional investment funds.

Provides effective diversification for investment portfolios.

Benefits of a Hedge Fund of Funds

Provides an investment portfolio with lower levels of risk and can deliver returns

uncorrelated with the performance of the stock market.

Delivers more stable returns under most market conditions due to the fund-of-

fund managers ability and understanding of the various hedge strategies.

Significantly reduces individual fund and manager risk.

Eliminates the need for time-consuming due diligence otherwise required for

making hedge fund investment decisions.

Allows for easier administration of widely diversified investments across a large

variety of hedge funds.

Allows access to a broader spectrum of leading hedge funds that may otherwise

be unavailable due to high minimum investment requirements.

Is an ideal way to gain access to a wide variety of hedge fund strategies, managed

by many of the worlds premier investment professionals, for a relatively modest

investment.


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APPENDIX B: About Hedge Fund Indexes

ALTVEST

InvestorForce produces a family of 14 hedge fund indices, the master index (Altvesthedge fund index) and 13 sub-indices. The indices are equal weighted for all included

hedge funds that have complete performance records since trading commencement. The

master index and sub-indices commence January 1993. The number of funds included in

the indices will continue to grow as new funds meet the specified criteria. In the

following, the "current performance month" corresponds to previous calendar month (for

example, if March 2000 is the current performance month, April 2000 is the current

calendar month). Current performance month index returns will be updated everyday of the current calendar month as InvestorForce funds report and new funds are added on

InvestorForce. InvestorForce will freeze the current performance month return at 2300

hours on the last day of the current calendar month. Monthly historical numbers will

never be rebalanced to account for new funds added or funds removed.

Calculation Methodology

For each month the universe of funds that meet the specified criteria are groupedaccording to master and as well as sub-index. For each grouping an arithmetic average is

calculated for the given month.

Simple average of monthly rates of return:

Where Ri = rate of return (net of all fees) for the ith month since inception, and s = # of months since inception


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Master Index:

The master index is comprised of all funds on the InvestorForce database that havereported performance for the current month and provided complete performance records

since the time of trading commencement. All sub indices are comprised of funds that are

included in the master index.


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CSFB / TREMONT

Index Characteristics

The Credit Suisse/Tremont Hedge Fund Index is the largest asset-weighted hedge fundindex. Unlike even-weighted indices, it does not underweight top performers and

overweight decliners.

The Credit Suisse/Tremont Hedge Fund Index is broadly diversified, encompassing 424

funds (April 2006) across ten style-based sectors, and representative of the entire hedge

fund industry.

Index construction is fully transparent, with unbiased, rules - based selection criteria and

published constituents. Rigorous reporting standards are required of member funds,

including monthly performance disclosure and audited financial statements.

Credit Suisse / Tremont Hedge Fund Index Specifications

The industrys first asset-weighted hedge fund index. Provides investors with the first

suite of indices designed from the ground up to provide meaningful performancemeasurementnot built around an investable product.

Composite Index comprised of ten style-based sector indices Funds drawn from the

Credit Suisse/Tremont database of approximately 4500 funds

Selection universe consists of funds meeting Credit Suisse/Tremont minimum criteria:

Timely and accurate NAV reportingevery month

Audited financial statements

At least $50 million under management

One-year track record (discretionary exceptions for funds


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With more than $500 million under management) Index represents at least 85% of assets

under management in selection universe for each sectortotal composite Index

membership of 424 funds (April 2006).


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EACM-100 ONSHORE

The EACM100 Index is an equally-weighted composite of 100 hedge funds selected

by EACM Advisors LLC (EACM) to be a representative sample of the various hedge

fund strategies available to investors. EACM100 is designed to be an intelligent

benchmark, with manager participation based on both quantitative and qualitative factors.

The EACM100 Index is not a database . It is an investable group of 100 investment

managers, chosen by the investment professionals at EACM to effectively sample the

universe of hedge fund styles. Managers are grouped into 5 broad investment strategies,

which are further cut into 12 sub-strategies. Performance results are calculated at each

level to provide a better understanding of strategy and sub-strategy performance. TheIndex is useful as a diversified composite of hedge fund styles or as selected strategies

and/or sub-strategies.

The EACM100 Index is designed to mimic a reasonably constructed fund of hedge

funds product. Specific strategy weights are set by EACM, using an investment-driven

approach.

Individual managers are always equally weighted at the beginning of each calendar year,

with each manager representing 1% of the total index. This approach provides a useful

framework for analysis and avoids the pitfalls of a haphazard grouping of managers

whose strategy weights are solely determined by availability of data.

Manager Selection

Performance is not the key factor to manager selection . The investment professionalsat EACM carefully review the investment discipline of each manager and select only

funds, which are representative of a specific trading style. Inclusion in the Index is not

contingent on any prior business arrangement with EACM, nor do investment managers


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pay any fees to participate. However, managers do agree to a number of terms and

conditions.

Each manager must have at least a two-year live performance record, a minimum of $20

million in the investment strategy, be open for new investments, and provide at least

annual liquidity. Only managers with both an onshore and offshore version of the same

product can be considered. Managers also agree to provide monthly performance results

on a timely basis, including any and all revisions, and to provide fund documentation,

such as offering memoranda and audited financials. Performance is also not a cause for

removal from the EACM100. Funds are dropped from the Index for a variety of

reasons, but poor performance will result in removal only where a blow-up situation

occurs and the fund dissolves. During a blow-up situation, the complete results of theailing fund are reflected in the Index totals. More common reasons for manager

replacements include straying from the investment strategy, a lack of adequate assets

under management, not being open to new investments or simply closing-up shop. The

manager line-up is reviewed on an annual basis and substitutions are made at the

beginning of each calendar year. In the case of managers dropping out during the year, a

special rebalancing is performed at mid-year. Manager selection or removal is not a

capricious act; it is a well thought out decision, made only after careful review.


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HFR HEDGE FUND INDEX (HFRI)

Methodology

The HFRI Monthly Indices (HFRI) are equally weighted performance indexes, utilized

by numerous hedge fund managers as a benchmark for their own hedge funds. The HFRI

are broken down into 37 different categories by strategy, including the HFRI Fund

Weighted Composite, which accounts for over 1600 funds listed on the internal HFR

Database. Due to mutual agreements with the hedge fund managers listed in the HFR

Database, we are not at liberty to disclose the particular funds behind any index to non-

database subscribers.

Funds included in the HFRI Monthly Indices must:

Report monthly returns Report Net of All Fees Returns Report assets in USD

Indices Notes:

All HFRI Indices are fund weighted (equal weighted). There is no required asset-size minimum for fund inclusion in the HFRI. There is no required length of time a fund must be actively trading before

inclusion in the HFRI.

The HFRI are updated three times a month: Flash Update (5th business day of themonth), Mid Update (15th of the month), and End Update (1st business day of

following month) The current month and the prior three months are left as estimates and are subject

to change. All performance prior to that is locked and is no longer subject to

change.


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If a fund liquidates/closes, that fund's performance will be included in the HFRI

as of that fund's last reported performance update. The HFRI Fund of Funds Index is not included in the HFRI Fund Weighted

Composite Index. Both domestic and offshore funds are included in the HFRI. In cases where a manager lists mirrored-performance funds, only the fund with

the larger asset size is included in the HFRI.


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HENNESSEE HEDGE FUND INDEX

The Hennessee Hedge Fund Indices are calculated from performance data supplied by a

diversified group of hedge funds monitored by the Hennessee Group LLC. The

Hennessee Hedge Fund Index is believed to represent over half of the capital in the

industry and is an equally-weighted average of the funds in the Hennessee Hedge Fund

Indices. The funds in the Hennessee Hedge Fund Index are believed to be statistically

representative of the larger Hennessee Universe of over 3,000 hedge funds and are net of

fees and unaudited. Past performance is no guarantee of future returns.

Conditions for inclusion in the index are as follows:

The firm should have at least $10 million in hedge fund assets. The fund should have at least 12 months of track record. An exception will be

extended to any firm, which has over $100 million in hedge fund assets. The fund should satisfy the Hennessee Group LLC reporting requirements. Funds are not eliminated from the index unless they are liquidated or fail to

satisfy the inclusion criteria, as set forth above. If eliminated, the fund's past

performance will remain in the index in order to avoid survivorship bias.

Rebalancing of the index will take place on an annual basis.


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MSCI HEDGE INVEST INDEX

The MSCI Hedge Invest Index is designed to be both investable and to reflect the overall

structure and composition of the hedge fund universe.

The MSCI Hedge Invest Index aims to reflect the overall structure and composition of the

hedge fund universe from the funds available on a hedge fund platform managed by

Lyxor Asset Management. The funds on the platform available for the index offer weekly

liquidity.

To replicate the characteristics of the overall hedge fund universe, MSCI starts with theMSCI Hedge Fund Composite Index, constructed independently of any hedge fund

platform, and identifies the most liquid and significant investment segments. The

investable index is rebalanced quarterly and the indicative index performance is

published daily on www.msci.com and Bloomberg.

At the October 2005 Quarterly Index Review, the number of funds in the MSCI Hedge

Invest Index increased to 125, with the investment segment weights set forth below. Note

that the number of funds included in the index is expected to grow as the platform

expands.


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A minimum of 100 funds is required for the preliminary index, a minimum of 800 funds

is required for the mid-month index, and a minimum of 1,000 funds is required for the

month-end index. The actual number of constituents for these indices often greatly

exceeds the minimum requirements, especially for the preliminary and month-end

indices.


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APPENDIX C: About Market Indexes

DOW JONES INDUSTRIAL AVERAGE

Overview

When Charles H.Dow first unveiled his industrial stock average on May 26, 1896, the

stock market was not highly regarded. Prudent investors bought bonds, which paid

predictable amounts of interest and were backed by real machinery, factory buildings and

other hard assets.

Today, stocks are routinely considered as investment vehicles, even by conservative

investors. The circle of investors has widened far beyond the Wall Street cliques of the past century to millions of everyday working men and women. These people are turning

to stocks to help them amass capital for their children's college tuition bills and their own

retirements. Information to guide them in their investment decisions is abundantly

available.

The Dow Jones Industrial Average played a role in bringing about this tremendous

change. One hundred years ago, even people on Wall Street found it difficult to discern

from the daily jumble of up-a-quarter and down-an-eighth whether stocks generally were

rising, falling or treading water. Charles Dow devised his stock average to make sense

out of this confusion. He began in 1884 with 11 stocks, most of them railroads, which

were the first great national corporations. He compared his average to placing sticks in

the beach sand to determine, wave after successive wave, whether the tide was coming in

or going out. If the average's peaks and troughs rose progressively higher,then a bull

market prevailed; if the peaks and troughs dropped lower and lower, a bear market was

on.

It seems simplistic nowadays with myriad market indicators, but late in the Nineteenth

Century it was like turning on a powerful new beacon that cut through the fog. The

average provided a convenient benchmark for comparing individual stocks to the course

of the market, for comparing the market with other indicators of economic conditions, or


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simply for conversation at the corner of Wall and Broad Streets about the market's

direction.

The mechanics of the first stock averages were dictated by the necessity of computing it

with paper and pencil: Add up the prices and divide by the number of stocks. Thisapplication of grade-school arithmetic, while creative is hardly worthy of remembrance

more than a century later. But the very idea of using an index to differentiate the stock

market's long-term trends from short-term fluctuations deserves a salute. Without the

means for the ordinary investor to follow the broad market, today's age of financial

democracy (in which millions of employees are actively directing the investment of their

own future pension money and as a result are substantial corporate shareholders) would

be unimaginable.

Following the introduction of the 12-stock industrial average in the spring of 1896, Mr.

Dow, in the autumn of that year, dropped the last non-railroad stocks in his original

index, making it the 20-stock railroad average. The utility average came along in 1929

(more than a quarter-century after Mr.Dow's death at age 51 in 1902) and the railroad

average was renamed the transportation average in 1970.

At first, the average was published irregularly, but daily publication in The Wall Street Journal began on Oct. 7, 1896. In 1916, the industrial average expanded to 20 stocks; the

number was raised again, in 1928, to 30, where it remains. Also in 1928, the Journal

A Performance Analysis of the Hedge Funds Industry

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