Hedge funds have proven to be worthy financial instruments over the past 20 plus years, and have contributed to the growth of the modern financial industry. The addition of a well diversified group of hedge funds to a traditional portfolio has been shown to be an effective way to potentially increase returns, while also preserving capital during adverse market environments. Going into 2010, the hedge fund industry appears to be healthier than it has been in more than a decade, albeit much smaller in terms of assets than it was at its peak two years ago.

1. Hedge Funds: A Look Back and a Look Ahead
By Edward H. DeFrance and Michael J. Kelly
Synopsis
CRITICAL OBSERVATIONS:
Hedge funds have proven to be
• Including a group of broadly diversified hedge funds in a traditionally allocated portfolio worthy financial instruments over
of stocks and bonds has been shown to potentially reduce portfolio volatility and the past 20 plus years, and have
increase return.
contributed to the growth of the
• The investment environment for hedge funds going forward (2010 and beyond) could modern financial industry. The
be attractive. Investment strategies that can make money in rising and falling equity addition of a well diversified group
markets, such as those employed by many hedge funds, are better positioned for success
of hedge funds to a traditional
in an uncertain/volatile economy.
portfolio has been shown to be an
• Hedge funds and the interests of their constituents are better aligned now than they
effective way to potentially increase
were prior to 2008.
returns, while also preserving capital
• Due to the fallout of 2008 and the Bernie Madoff scandal, investors are assigning more
during adverse market environments.
value to the strength and integrity of a firm’s risk controls and procedures when
conducting due diligence on potential hedge fund investments, as opposed to focusing
While hedge funds have remained
only on performance. somewhat of a mystery to the general
public, and are often vilified by the
• Investors are seeking better transparency, better liquidity, and more appropriate fee
structures from funds. mainstream media (they were referred
to as an “evil virus” in a 2005 Newsweek
• Investors are requiring the use of independent, third-party services to support funds’
operations, manage custody of their assets and verify fund pricing.
article for example), the reality is that
many institutions and high-net-worth
• Fund of hedge funds (FoHFs) will continue to be a major channel into hedge funds,
providing more investors ease of access and exposure to a broad range of investment
investors have invested in hedge funds
styles and strategies, along with an additional level of risk management. for many years, and continue to do so
as a means to add diversification to
their portfolios.
Going into 2010, the hedge fund
industry appears to be healthier than
it has been in more than a decade,
albeit much smaller in terms of
assets than it was at its peak two

2. years ago. While 2008 was without In 2009, investors are already starting
doubt one of the most challenging to reap the benefits of this new
investment environments we have hedge fund world order, as industry
seen this century, the hedge fund returns appear to be on pace to
industry emerged from the crisis reach 10-year highs. Looking ahead,
case-hardened and remains a viable reduced competition and major
compliment to traditional stock and macroeconomic trends could lead to
bond investing. From an investment above average returns.
opportunity standpoint, the landscape
is attractive as many asset classes are A History of Success …
offering substantial risk premiums and Misunderstanding?
and competition has significantly “It is the nature of humans to
diminished (with weaker, less- fear what it is they do not know
qualified hedge funds closing in 2008, or understand.”
fewer asset managers are chasing ~ Rod Serling, creator of
similar trades – leaving more pie for The Twilight Zone
the worthy survivors to share).
Clearly, hedge funds have played an
For investors, the most tangible important part in the expansion of
positive outcome left by the shock of capital markets in recent years. Since
2008 has been a humbling of sorts for 1990, hedge funds have represented
the industry. Many previously closed one of the fastest growing segments
hedge funds have now opened their of asset management. The number
doors to accept new capital, are much of hedge funds around the world
more willing to be flexible on fees and exploded from 610 in 1990 to
lock-up periods, and – perhaps most approximately 9,000 by the end
significantly – are much more willing of 2008.1 Over the same period,
to pull back the curtain and share industry assets under management
information about their success. grew exponentially as well, from
$39 billion to an all-time high of
GRAPH 1: $1.9 trillion by the second quarter
Total Hedge Fund Assets of 20082 (Graph 1).
December 1990 through June 2009 Estimate For something that has grown so
$2,100
$1,868
rapidly and become such an integral
part of the global financial system
$1,600
Hedge Fund Assets ($ billion)
$1465
$1407 through the years, there is still a
$1,100 $973
$1105
$1000
general lack of understanding about
$820 the hedge fund industry. Indeed, it
$626
$600
$456 $491
$539 is often surprising to those of us who
$368 $375
$168 $167 $186
$257
work in the industry just how much
$100 $58 $96
$39
misinformation is circulated, not
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Jun 09
$(400)
just among small investors, but even
Source: HFR Global Hedge Fund Industry Report, second quarter 2009. Hedge Fund Research, Inc.,
at the highest levels of sophisticated
August 2009, www.hedge-fundresearch.com institutional asset management.
240%
190%
Bonds
-2- Hedge Funds
ive Return
140% Stocks

3. The confusion, and in some cases “Absolute” Returns
Hedge Funds: A Primer controversy, over hedge funds is By design, most hedge funds are
What is a hedge fund? likely a function of their private intended to provide consistent
• he term ‘hedge fund’ refers to
T structure. As opposed to a mutual positive returns regardless of the
pooled investment structures fund, almost all hedge funds are direction of the broad markets,
• edge funds may utilize a broad
H private offerings because they are not utilizing a wide variety of financial
array of financial instruments to sold publicly on open exchanges.
instruments to do so. This approach
generate performance Because of this, the Securities and
stands in contrast to that of traditional
• here are many types of hedge
T Exchange Commission strictly limits
managers, who measure themselves
funds using many different the amount of information that
in relative terms and are prepared to
investment strategies can be shared about them with the
accept losses in value, if those losses
• ension funds, endowments,
P general public.
insurance companies, private banks,
are less than a stated benchmark
and high-net worth individuals and
As such, many investors consider (such as the S&P 500 Index).
families invest in hedge funds hedge funds highly risky, highly
Hedge funds have, for the most part,
aggressive and somewhat speculative
• any hedge funds attempt to achieve
M succeeded in achieving this goal
positive returns in both rising and investments. Sensationalized hedge
and in preserving capital during bear
falling capital market environments fund blow-ups and frauds, like Long
markets. From 1990 to 2008, the
• he inclusion of hedge funds in a
T Term Capital Management or the
industry experienced only two down
traditional portfolio is intended to Madoff scandal (see page 5) naturally
years, weathering difficult periods
add diversification, reduce risk and contribute to this misconception.
like the Mexican peso crisis, the
potentially increase returns While in some cases this is true, the
Asian financial crisis, the collapse of
• edge funds seek to maintain low
H reality is that there are a wide variety
correlations (definition on page 4) of different types of hedge funds, Long Term Capital Management, the
with traditional assets classes (stocks each utilizing different levels of risk bursting of the dot-com bubble, and
and bonds)
and each seeking different types of the collapse of the credit markets in
• ost hedge funds do not measure
M
$2,100
returns. Many hedge funds actually 2001-2002. From a performance
$1,868
$2,100
themselves against traditional market
$1,600 pursue very conservative strategies
$1,868 perspective, hedge funds have been
Hedge Fund Assets ($ billion)
$1465
benchmarks (like the S&P 500 Index)
$1,600
that target modest but consistent successful in achieving their objective
$1407
Hedge Fund Assets ($ billion)
$1465
but instead target “absolute” returns $1407
of providing consistent returns that
$1105
$1,100
(positive performance regardless of returns and – above all – relatively
$1105
$973 $1000
$1,100
low risk.
$973 $1000
exhibit low correlation to the broad
$820
the direction of the broad markets) $820 $626
$600
$600 $539
$626
$368 $375
$456 $491
$539
equity markets, while maintaining
$456 $491
$257
$368 $375
$58 $96
$168 $167 $186
$257
low volatility (Graph 2).
$168 $167 $186 $100
GRAPH 2:
$100 $39 $58 $96
$39
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Jun 09
Hedge Funds at Work – Providing Consistent Returns
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Jun 09
$(400)
$(400)
Cumulative Return and Value of $1 Million Investment
October 1994 through September 2009
240%
240%
190% 190% Bonds: $1.91 million
BondsBonds: $2.78 million Bonds
Hedge Funds:
Hedge Funds
Hedge Funds: $2.52 million Hedge Funds
$1.84 million
Cumulative Return
Cumulative Return
140% 140% Stocks Stocks
Stocks: $2.29 million
90% 90%
All data is sourced from Pertrac. Hedge funds are
40% represented by the Edhec Fund of Hedge Funds Index.
40%
Stocks: $1.31 million Global equities are represented by the MSCI World
Equity Index. Bonds are represented by the Barclays
-10% US Corp. IG Index. Please see page 11 for additional
-10%
information on data sources.
4
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96
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14%
14% -3-
Risk reduced by 28%
12% 11.6% Risk reduced by 28%
12% 11.6% Return Increased
10% by 3% Return Increased

4. Going Mainstream recently demonstrated an ability to
Demonstrating success during the add value to a traditional portfolio
2000-2002 bear market, hedge allocation, by both enhancing returns
funds essentially signaled their arrival and reducing risk (see Graph 3).
to the world. What had been until
Growth and Consequences
then a vehicle that only the most
$2,100
Correlation is a statistical measure of sophisticated and ultra-high-net- As a by-product of this surge in
how two securities move in relation to investor appetite, industry assets
worth investors were privy to – or
$1,868
each other. Perfect positive correlation
$1,600 interested in, for that matter – hedge under management grew
Hedge Fund Assets ($ billion)
implies that as one security moves, $1465
$1407
either up or down, the other security funds began garnering attention from substantially. From 2000 to 2008,
$1105
$1,100
will move in lockstep, in the same other parts of the investor spectrum,
$973 hedge fund assets expanded 20%
$1000
direction. Alternatively, perfect negative most $626
$820
notably institutions and other per year,3 growing nearly four times
$600 correlation means that if one security $456 wealthy investors.
$491 $539 in size since 2000.4 There were some
$368 $375
moves in either direction the $257
security negative consequences of this
$100
$168 $167 $186
that is$58 $96 negatively correlated
perfectly Institutions began seeking them out
$39
exponential growth: transparency
will move by an equal amount in the much more frequently as a source
levels were not satisfactory, as
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Jun 09
$(400) opposite direction. If the correlation is 0, of diversification and “absolute”
investors often acquiesced to
the movements of the securities are performance following on the stable
said to have no correlation; they are manager’s preferences for secrecy;
returns hedge funds had demon-
% completely random. due diligence standards were often
strated during the dot-com bust.
compromised (as was clearly the
Sustained low interest rates during
% case for some feeder funds directing
this period, coupled with a flat Bonds
Hedge their clients to Madoff); and poor
equity environment, also contributed Funds
Stocks liquidity management practices
%
to this interest. From a performance
emerged, high-lighted by the high
perspective, a broadly diversified
number of funds who gated their
%
portfolio of hedge funds has fairly
investors in 2008.
% Extreme growth also diluted the
GRAPH 3:
quality and skill of fund managers.
% Hedge Funds at Work – Benefits to Traditional Portfolio Previously, hedge fund managers had
been Wall Street’s best and brightest.
4
95
96
6
97
98
8
99
00
0
01
02
2
03
04
4
05
06
6
07
08
8
09
t9
t9
t9
t0
t0
t0
t0
t0
Impact on Risk and Return – October 1994 through September 2009
n
b
n
b
n
b
n
b
n
b
n
b
n
b
n
Oc
Oc
Oc
Oc
Oc
Oc
Oc
Oc
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Fe
Fe
Fe
Fe
Fe
Fe
Fe
14%
However by late 2006, anyone with a
11.6%
Risk reduced by 28% financial calculator suddenly believed
12%
Return Increased he or she was qualified to do the job.
10% by 3%
8.3%
Annualized Volatility
8%
6.4% 6.6%
Annualized Volatility
(Risk)
6%
(Risk)
Annualized
Annualized
4%
Return
Return
2%
0%
Traditional Portfolio Traditional Portfolio with Hedge Funds
(70% stocks, 30% bonds) (40% stocks, 30% bonds, 30% hedge funds)
Volatility is measured by standard deviation. Standard deviation is a measure of the dispersion versus
the mean or experienced value: the higher the standard deviation, the greater the volatility. Please see
page 11 for additional information on data sources.
-4-