## Illuminating the World of Hedge Funds

Illuminating the World of HEDGE FUNDS " The logic of the idea was very clear. It was a hedge against the vagaries of the market. You can buy more good stocks without taking as much risk as someone who merely buys. " presented by PERTRAC Alfred Winslow Jones The Institutional Investor Journal, August 1968 BRIEF HISTORY of HEDGE FUNDS Regulation of U.S. securities industry begins with the Securities Act of 1933. Regulation D exempts companies selling to "accredited investors" from registering. Publishes artietgazine on Alfred Alternative Investment Management Association (AIMA) formed to represent all practitioners SEC adopted rules requiring registered advisors with $150 million or more in AUM to report comprehensive fund information. Fortune Winslow Jonee' hedge fund - number of hedge funds grows in the following years. in the alternative investment management industry. PERTRAC European Federation of Investment Funds and Companies (FEFSI) established - later renamed European founded Regulation of U.S. funds begins with passage of the Investment Company Act of 1940. Financial Services Authority (FSA) established to regulate the UK financial services industry. Fund and Asset Management Association (EFAMA). 1933 1934 1940 1949 1966 19б9 1974 1990 1991 1996 2001 2002 2011 2012 Managed Funds Association (MFA) Committee of European Securities Regulators (CESR) established - later replaced by the European Securities and Markets Authority (ESMA) in 2011. Securities Exchange Act of 1934 establishes the JOBS Act passed. Allows hedge funds to market themselves to a broader audience. Rothachild Family introduces the world's Securities and Exchange Commission (SEC). is formed to advocate on behalf of hedge funds and managed futures firma. first fund of hedge funds. Alfred Winslow Jones for ms first hedge fund (coining them "hedged funds") and eventually introduces the 20% performance fee. Commodity Futures Trading Commission (CFTC) established. Commodity Trading Advisors (CTAS), or commodity pools, are generally required to register with the CFTC. Hedge Fund Association (HFA) founded to advocate on behalf of amaller and emerging hedge funds. "UCITS IIr' Directives released in Europe allowing UCITS to employ alternative strategies. Total reported Assets Under Management (AUM) of hedge funds and funds of hedge funds at the end of first half 2012. If %24 $ 2.317 trillion} broken down into individual U.S. dollar bills and placed side by side, they would circle the equator 9,017 times or go to the moon and back 470 times. 29% 15% Long/Short Equity CTA/Managed Futures The Most Popular HEDGE FUND STRATEGIES 12% Emerging Markets ....... .. .. .. .. . , . .. . . 1.... .... . 10% Global Macro 6% Fixed Income V %9 6% Event Driven Relative Value Multi Strategy 12% Other North America Municipalities Europe 6,178 4,092 Funds of Hedge Funds University Endowments Hedge Funds are on Every CONTINENT South America Asia 1,267 637 Australia Africa 165 Hedge Fund Investors are DIVERSE Family Offices Sovereign Wealth Funds *Except for Antarctica Foundations & Charitable Organizations Individual Investors NUMBER OF HED GE FUNDS AND FUNDS OF HEDGE FUNDS REPORTING A GIVEN DOMICILE Fire, Police, Teacher & Other Pensions WEALTH is Relatively Concentrated } $ size of the assets under management in billions of USD based on management company location USA UK Switzerland Luxembourg Brazil France Netherlands Germany Sweden Bermuda $1124 $483 $127 $89 $88 $66 $49 $34 $34 $27 out of 4 FUNDS Where is All the Money in CTAS & MANAGED FUTURES FUNDS are denominated in the US Dollar or Euro PER CENT OF TOTAL AUM BY FUND SIZE 1.1% $25M 56% 21% 7% 4% 3% 5% 1.1% $25-5OM 1.8% $51-100M 78.1% 4.7%.. $101-250M >$1B $ € R$ ¥ £ E 5.0% $251-500M US Dollar Brazilian Chinese Real Swiss Franc Euro UK Pound Other Yuan 8.2% $501M-1B GOOD THINGS COME IN SMALL PACKAGES Smaller Funds Tend to Outperform Larger Funds... .But Larger Funds are Generally Less Volatile CUMULATIVE PERFORMANCE BY SIZE OF FUND ANNUALIZED VOLATILITY BY SIZE OF FUND January 1996 to December 2010 January 1996 to December 2010 16.95% STANDARD DEVIATION 700% 15.94% 15.96% 577% 500% 17.57% SEMI 370% 16.10% 6.01% DEVIATION 300% 14.90% 14.18% 14.08% 318% LOSS DEVIATION 100% DOWNSIDE 14.07% 3.54% | 3.58% DEVIATION 0% (5%) DEC DEC DEC DEC DEC DEC DEC DEC 1996 1998 2000 2002 2004 2006 2008 2010 0% LARGE > $500M AUM SMALL MID-SIZE < $100M AUM $100 - 500M AUM LOSS DEVIA TION DOWNSIDE DEVIATION (5%) measures the volatility of returns below a Minimum Acceptable Return (MAR), STANDARD DEVIATION SEMI DEVIATION measures the volatility of returns from the mean measures the volatility of returns measures the volatility of returns from the mean only during perioda below the mean of a loas offered here at 5% If You've Made it This Far... It's Time for Some More Advanced Analysis IT'S ALL GREEK TO ME } Some Common Investment Statistics SYMBOL DEFINITION WHAT IT ATTEMPTS TO ANSWER THE FORMULA FOR YOUR INNER MATH GEEK Where Ma = The mean return of the benchmark Where Mp = The mean return of the fund How much extra did you earn from a fund that you wouldn't have otherwise earned from investing in the broad market? Measures the fund's value relative to a benchmark. Alpha Alpha = MED - Beta x M R Where R1= The return of the benchmark for period I Where RD, = The return of the fund for period I Where MR = The mean return of the benchmark Measures the fund's sensitivity to movements of the market as a whole How likely is your fund to track the benchmark? Where MED = The mean return of the fund Where N = Number of periods Beta (Ï (R, - M,)(RD, - M ) + (Ï (R, - M2)² Beta = I-1 Where r is the threshold return, and Fis cumulative density function of returns. Uses actual return distribution and divides expected returns into gains and losses to provide a relative measure of the likelihood of the fund achieving a given return. How do your fund's good returns stack up to its bad returns, and how likely is it that your fund will make more than a given percentage? S(1-F(x))dx Omega n(r) = SFOX)dx Where R1= Return for period I Where MR = Mean of return set R Where N= Number of periods Measures the degree of variation of the How much should you expect your fund's returns to vary from the norm? fund's returns around the fund's mean (average) return for a specified period. M, = (I R,) + N Sigma (Standard Daviation) Standard Deviation = (i (R, - M, - (N - 1) ) Annualized Standard Deviation = Monthly Standard Deviation x (12 )a UNDERSTANDING the MOMENTS of a DISTRIBUTION u = Mean MEAN 1st The average of returns. In other words, it's the average. Moment O = Standard Deviation VARIANCE 2nd Measures the distance of returns from the mean. In other words, variance shows how frequently possible Moment returns occur. х -Зо -20 -10 1o Зо POSITIVE SKEW (returns more likely to be to the left of the mean) NO SKEW (returns equally likely to be to the left and to the right of the mean) NEGATIVE SKEW (returns more likely to be to the right of the mean) SKEWNESS Mode ум Mode Characterizes the degree of asymmetry of a distribution around its mean. In other words, by using akewness investors should be able to better predict whether a return is more likely to occur to the left or to the right of the mean. Зrd Median Median Moment Median Mode LEPTOKURTIC MESOKURTIC PLATYKURTIC (high peak) (normal distribution) (flat topped) KURTOSIS 4th Characterizes the relative peakedness or flatness of a distribution. In other words, kurtosis helps investors better predict the likelihood of a given return (or loss). Moment IMAGINING THE UNIMAGINABLE } Keeping a Portfolio Protected TRADITIONAL RISK STATISTICS Traditional risk statistics assume that events to the left and right of the mean are equally likely to occur. Extreme Extreme Negative Event (Loss) Occurs Here For example, traditional risk approaches assume that the likelihood of an extreme event Positive Event (Gain) Occurs Here (negative or positive) is very slim. These extreme events are modeled by the tails of the normal distribution. 0.135% 0.135% За -20 -10 10 За chance chance Value at Risk (VaR) is the maximum loss a fund can expect within a specified holding period using a specified confidence level. It is calculated using Traditional Risk Statistics based on a Normal Distribution, with No Skew, and Mesokurtic Kurtosis. FAT-TAIL RISK STATISTICS The traditional VaR model has come under criticism because, in the real world, events can't be easily modeled on a simple, symmetrical curve (normal distribution). Newer, Fat-Tail VaR models better capture the fact that highly improbable and damaging events do occur, and can occur more frequently than traditional risk statistics assume. Nassim Nicholas Taleb popularized the use of the term "black swan" for these highly improbable events. Notice that the tail is “fatter" to the left of 95% VaR. This indicates that the probability of sustaining losses has increased. In this example, both the Fat-Tail and normal distributions have An asymmetrical curve, based on real-world returns, can more accurately predict the chance that an extreme negative event (loss) or an extreme positive event (gain) may occur. 95% the same mean and VaR 95% numbers, but the Fat-Tail distribution is Leptokurtic and has a left ske. VaR As a result, the Fat-Tail. distribution's Expected Tail Loss (ETL), which is the average of returns that exceed the VaR, more accurately captures a higher downside risk than traditional ETL. The overstated probability that an extremely positive event (gain) occurs according to the traditional risk approach. Traditional ETL Fat-Tail ETL "One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly) black bird." Nassim Nicholas Taleb The Black Swan: The Impact of the Highly Improbable Images are for illustration purposes and are not to scale www.pertrac.com Office locations and telephone numbers: [email protected] New York: +1 212.661.6050 PERTRAC London: +44 (0)20. 7651.0800 pertrac.com/blog Hong Kong: +1 852.2526.9780 f facebook.com/pertrac Tokyo: +81.3.5785.2041 © 2012 PerTrac Reno: +1 775.851.2282 @PerTrac Memphis: +1 901.888.7300 .......... ...... 10

# Illuminating the World of Hedge Funds

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