Hedge Fund Scoring

Hard and Soft Information

Disclaimer

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About BSP

• Focus on the Hedge Fund Universe

• Provide Advisory services on Hedge

Fund Portfolios

• Combine quantitative and qualitative

analysis in the process of Hedge Fund

Scoring and portfolio construction

Rationale for seeking Alpha in the Hedge Fund universe

Rationale for seeking in the Hedge Fund Universe vs. the traditional Long only universe:

1. Freedom to express investment thesis

2. Potential larger compensation

3. Control on Flow of Funds/Level of Assets Under Management due to better alignment of interests between fund manager and investors

Hedge Funds

“Traditional”/

Long Only

Funds

1. Investment Universe

Source:

Bloomberg

2. Fee Structure

The fee structure in the Hedge Fund Universe typically consists of both Management & Performance based Fees (2% & 20%)

The potential higher compensation attracts talented managers to the Hedge Fund Universe

The higher fees create a higher Alpha threshold vs. Passive investment vehicles

Source:

Bloomberg

3. AUM Control

• It is not uncommon for Hedge Funds to

return capital to investors if they think

their AUM has grown too much

• It is even more common for Hedge

Funds to “close” for new investments in

order to sustain Excess performance

3. AUM Control

• It is not uncommon for Hedge Funds to

return capital to investors if they think

their AUM has grown too much

• It is even more common for Hedge

Funds to “close” for new investments in

order to sustain Excess performance

3. AUM Control

Source: FT

3. AUM Control

Source: NY Times

Long Short Equity Hedge Fund Indices vs. Peers

Long Short Equity Hedge Fund Indices vs. Peers

Equity Mutual Funds – US Large Cap Index

R2=0.96

Equity Mutual Funds – US Large Cap Index36 months Rolling ; vs. S&P 500

Equity Mutual Funds – US Index

R2=0.92

Equity Mutual Funds – US Index36 months Rolling ; vs. S&P 500

Equity Mutual Funds – US Index

R2=0.83

Equity Mutual Funds – US Index

R2=0.92

Long/Short Equity Hedge Fund Index

R2=0.64

Long/Short Equity Hedge Fund IndexDJ CS Long/Short Equity Index, 36 Months Rolling ; vs. S&P 500

Long/Short Equity Hedge Fund IndexHFRI Equity Hedge Index

R2=0.72

Long/Short Equity Hedge Fund IndexHFRI Equity Hedge Index, 36 Months Rolling ; vs. S&P 500

Long Short Equity Hedge Fund Indices vs. Peers

BSP empirical findings

• Talent is scarce (even in the HF universe…)

• Past performance is not necessarily indicative of future performance

• Consistent Statistically significant Alpha generation in the past (=investment skills) + robust risk management is indicative of Alpha generation in the future

• Combining Quantitative and Qualitative analysis enhances Hedge Fund Selection skills

Lessons from Four Hedge Funds:Analysis of Data/information pre 2008 crisisand outcome in 2008 & onwards (“post crisis”)

Fund I & Fund TPre-Crisis

• Both funds are classified as Multi-Strategy Funds

• Both funds are active since the early ‘90s

• Both funds Majority Gross exposure is in the Equity universe

• Both funds had 85%+ positive months in the 5 years prior to 2008 vs. 72% for S&P 500

• Both funds had an annualized standard deviation lower than 5.2% in the 5 years prior to 2008 vs. >8.5% for S&P 500

Funds I & T, Accumulated PerformancePre-Crisis

Funds I & T, Accumulated PerformancePre-Crisis

Funds I & T, Accumulated PerformancePost-Crisis

Fund I & Fund TPost-Crisis

• Both funds are classified as Multi-Strategy Funds

• Both funds are active since the early ‘90s

• Both funds Majority Gross exposure is in the Equity universe

• Fund I had 80%+ positive months post crisis. Fund T had 67% positive months post crisis vs. 59% for S&P 500

• Fund I had an annualized standard deviation lower than 5.2%. Fund T had an annualized standard deviation of 11.3% vs. 20% for S&P 500

Fund I & Fund T

Was there any indication in the available

data pre-crisis to indicate:

• The consistency in performance

between Fund I pre-crisis & Fund I

post-crisis

• The inconsistency in performance

between Fund T pre-crisis & Fund T

post-crisis

Fund T36 Months rolling MLR vs. Dow Jones Credit Suisse HF Indices

Risk Arbitrage

Long/Short Equity

Long/Short EquityEvent Driven

Distressed

Fund T - Pre-Crisis36 Months rolling MLR vs. Dow Jones Credit Suisse HF Indices

Risk Arbitrage

Long/Short Equity

Event Driven

Long/Short Equity

Dedicated Short

Distressed

Fund T - Post-Crisis36 Months rolling MLR vs. Dow Jones Credit Suisse HF Indices

Event

Driven

Distressed

Fund I36 Months rolling MLR vs. Dow Jones Credit Suisse HF Indices

Event Driven

Fund I - Pre-Crisis36 Months rolling MLR vs. Dow Jones Credit Suisse HF Indices

Event Driven

Macro

Fixed Income

Arbitrage

Fund I - Post-Crisis36 Months rolling MLR vs. Dow Jones Credit Suisse HF Indices

Event Driven

Fund I & Fund T

• Assessing investment management skills in the past in order to project on the future requires investment strategy consistency

• Fund I had a consistent investment strategy while in Fund T there was a strategy drift

BSP has advised a full redemption of fund Twhich was executed through mid 2007.

BSP has advised to continue holding Fund I Pre and Post 2008.

Fund R & Fund J - Pre-Crisis

• Both funds are classified as Long/Short Equity Funds

• Both funds are active since the late ‘90s

For the 5 years prior to 2008:

• Fund R:

Alpha: 1% (Statistically significant, monthly vs. S&P500)

Beta: 0.24

• Fund J:

Alpha: 0.8% (Statistically significant, monthly vs. S&P500)

Beta: 0.19

Accumulated PerformancePre-Crisis

Accumulated PerformancePost-Crisis

Fund R & Fund J - Post-Crisis

• Both funds are classified as Long/Short Equity Funds

• Both funds are active since the late ‘90s

Post Crisis:

• Fund R:

Alpha: 0.1% (Statistically non-significant, monthly vs. S&P500)

Beta: 0.32

• Fund J:

Alpha: 0.7% (Statistically significant, monthly vs. S&P500)

Beta: 0.18

Fund R & Fund J

Was there any indication in the available

data pre-crisis to indicate:

• The consistency in Alpha generation in

Fund J pre-crisis & Fund J post-crisis

• The inconsistency in Alpha generation

in Fund R pre-crisis & Fund R post-crisis

Fund JPre-Crisis, Rolling 36 Months vs. S&P 500

Fund JPost-Crisis, Rolling 36 Months vs. S&P 500

Fund RPre-Crisis, Rolling 36 Months vs. S&P 500

Fund RPost-Crisis, Rolling 36 Months vs. S&P 500

The answer is not in the quantitative analysis but rather in the qualitative analysis.

Fund R, characteristics:

• Buy and Hold

• Hold/Increase positions when markets go against your investment thesis

Fund J, characteristics:

• Trading oriented

• Decrease Gross/Net/Position concentration when markets go against your investment thesis

Fund R & Fund J

Pre & Post Crisis trading environment

During 2007 when the credit crisis

materialized BSP has advised shifting the

Long/Short Equity books from a blend of

“buy an Hold” and “trading oriented”

managers to solely “trading oriented”

managers. As the latter are more fit to a

Macro uncertain and volatile

environment.

Fund R & Fund J

Summary

• There is a rationale for excess returns in

the Hedge Fund Industry

• There is supportive evidence for excess

returns in the Hedge Fund Industry

• Quantitative analysis must be

combined with Qualitative analysis to

support better investment decisions