Hedge Fund Strategies: A Do It Yourself Approach

Presentation by Stephen Stone SOA Annual Meeting October 26, 2004

Disclaimer

Presentation is for informational purposes only. No representation is being made that any company has implemented any strategy described in this presentation. The economics of any strategy needs to be independently verified. The accounting and tax impacts of any strategy mentioned here would need to be researched. Whether a specific strategy is statutorily permissible would need to be independently determined.

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Purpose of Presentation

Avoid investing in Hedge Funds that are taking the same risks you are! Invest in Hedge Fund strategies with the benefit of: o Avoid high fees. o RBC efficient? o Enhanced control having strategy managed in house.

Overview

Fundamentally, hedge funds need to: o Use leverage. o Short securities. Neither of these is generally allowed under insurance law, but there are exceptions: o Credit derivatives (leverage) o Asset hedges (short) o Covered calls (short) o Put options to hedge equities (short) o Make use of existing short positions (liabilities)
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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Credit Derivatives

GIC and funding agreement issuance: o Issue GIC and buy bond => CDS. o GIC business => Synthetic CDO. Credit Derivatives: o Used with existing assets is leveraged on a marginal basis. Simple example but it illustrates: o Invest in HF that invests in CDSs/CDOs if you are? o Though a leveraged, HF activity insurance companies are active due to core competency.
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Asset Hedges

Example = Butterfly Trading:

o

o o

Consists of a Short/Long/Short (or L/S/L) position in Fixed Income instruments. Typically done with neutral exposure to level and slope of yield curve. 3rd Principal Component is a strongly mean-reverting time series. Issue an IFA tied to 1-month LIBOR. Issue a 5 year GIC or funding agreement. Buy 2 & 3 year assets or swaps.

Positions:
o o o

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Covered Calls and Put Hedges

Call options have positive delta, so selling is equivalent to a short position in a stock. Put options have negative delta, so buying is equivalent to a short position in a stock. Can also add elements of volatility trading: o Short call is short volatility. o Long put is long volatility.

Make use of Existing Short Positions

CDS example: GIC and funding agreement issuance. Dynamic hedging instead of static hedging of EIAs or VA Guarantees. GICs/Funding agreements with embedded derivatives. Long/Short yield curve exposures in general ALM positions. Long/Short fixed income volatility exposures. Etc.

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

2004 SOA New York Annual Meeting

Asset/Liability Management in Insurance Companies Thoughts and Goals for the Next Generation Matt Halperin, CFA
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A Note
I will use GICs as my liability example to eliminate option risks that may need to be discussed in other products such as SPDAs. This just simplifies the discussion, the following analysis is robust enough to handle across many interest sensitive liabilities.

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

A Little History

A little stylized history of risk management in an insurance company. A life insurance company would sell a five year GIC at 12%. The investment department would underwrite a five year loan for 14%. After expenses, reserves etc, the Life Insurer would earn a steady profit over the next five years. The challenge to this program is what happened when rates dropped before the asset could be bought. By whatever amount rates dropped, profits were impacted. Enter hedging. Insurer would buy bonds or futures to hedge interest rate risk while waiting to deploy cash.

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Process Flow
Corporate Commits To GIC Life Insurer Actuary/Sales Notifies Investment Department Investment Department reacts. It sees there are no five year Notes to buy so it Buys five year note future

Trading desk buys A corporate bond and Sells the note future.

Gain or loss on the future Was amortized over the life of the asset.

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Mind The GAAP

GAAP accounting. Before, FASB 133, insurers operated believing that if they showed correlation between the hedge asset and hedge derivative of 80-125%, any gains or losses on the hedge could be amortized over the life of the acquired item. These rules originated with physical commodity (like wheat and soybeans) traders. Treasury securities do not get this deferral treatment. You sell a treasury security, and you recognize the gain or loss under GAAP. Once you started hedging interest rate risk, as an on-going business, you could sell GICs or buy(provided you had cash) assets at will.

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Spread Volatility

One could underwrite a mortgage, hedge the interest rate risk, and wait for the salesman to sell a GIC. The salesman could offer a better rate when the investment department bought a cheap asset. Life was good. Then spreads became volatile and tight.

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Swap Spread History

5 Year Swap Spread 120 100 80 60 40 20 0 1/1/90 1/1/91 1/1/92 1/1/93 1/1/94 1/1/95 1/1/96 1/1/97 1/1/98 1/1/99 1/1/00 1/1/01 1/1/02 1/1/03 1/1/04

5 year Swap Spread

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Swaps

An interest rate swap is a transaction where one party pays LIBOR and the other pays a fixed rate of some spread over the treasury curve. In this example, we have a five year swap with a spread of 60 basis points. Not a perfect hedge, but a good attempt.
Five year treasury plus sixty

Fixed Rate Payer

6 month LIBOR Paid semi-annually

Floating Rate Payer

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Derivatives

Lets look at derivatives for a minute. Historically, the first known future trade was when Plato predicted an impending olive shortage and bought part of the seasons olive crop before the crop was in. Futures developed in agricultural areas first, as a way for farmers to hedge their crop sales. The ability to arbitrage a future is a keep component for its success. Interest rate futures developed in the 1970s, first on mortgages and then on US Treasury 20 year bonds. Futures on indices and non-deliverables did not develop until the early 1980s since many states classified nondeliverable/cash settled futures gambling.
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Derivatives

Futures on corporate bonds, did not succeed since it was hard to arbitrage the future. You had to buy or short individual corporate bonds etc. Swaps developed in the 1980s as a way for some corporate issuers to arbitrage commercial paper and corporate bonds. Swaps became an alternative to futures to hedging rate risk.
Specific terms to match asset of liabilities.

Example Buy 10 year note, pay forward in 5 years for 5 years. Matches rate risk. Provides some credit spread protection.

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Credit Derivatives

What next? Credit derivatives. In the early 1990s, driven by new bank capital rules, a market for credit derivatives appeared. Banks would pay a premium to a buyer if they agreed to the credit risk on an individual name. In a typical trade, a bank pays insurer 100bps a year for 5 years. If XYZ defaults, then insurer buys xyz bonds at 100 from the bank. This market for credit derivatives has grown from zero to $5.4 trillion in under 10 years. Seller of default protection may not even have exposure to the credit. We can bifurcate corporate bond risk into risk into treasury and credit.

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The Future

We have learned to manage duration risk. We can, kind of, hedge spread risk. Credit risk is now bifurcated from rate risk and it can be hedged. In equities, investors use the equation
Rmarket= Rfree+beta(Rmarket- Rfree)+alpha

A bond investor earns Treasury Rate+credit spread+optionoption

Mortgages are short call options. Corporate bonds may be long or short options The spread is the fixed income equivalent of alpha-what you earn for venturing into something riskier than Treasuries.

A hedge fund is an investment vehicle designed to capture alpha with no exposure to interest rates or equity beta.
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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Hedge Funds

Hedge funds are pools of capital that invest in securities, derivatives and other financial transactions. They operate with minimal regulation. Do not have the constraints that firms do that operate under the 1940 Act. Early hedge funds were long and short and thus hedged their exposure to markets. Market has grown and evolved over the last few years. Some hedge funds, still hedge.

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Alternative Asset Categories

Relative Value Hedge Funds Event Driven Hedge Funds Opportunistic Pre-IPO Hedge Funds Equity Macro Short Sellers Leveraged Long Equity Specialty Lending Venture Capital Private Equity Mezzanine Debt Real Estate

Convertible Bonds Risk Arbitrage Fixed Income Arbitrage Equity Market Neutral Capital Structure Arbitrage Distressed Debt

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Hedge Funds: Number of Funds & Dollars Under Management 1999-2003 2002

1999

2000

2001

2003

US Hedge Funds No. of Funds 4,150 4,250 4,400 4,600 4,875

$ Under Management (bn)

$255

$280

$315

$340

$420

Offshore Hedge Funds No. of Funds 2,050 2,250 2,600 2,900 3,225

$ Under Management (bn)

$225

$240

$285

$310

$400

Global Hedge Funds No. of Funds 6,200 6,500 7,000 7,500 8,100

$ Under Management (bn)

$480

$520

$600

$650

$820

2004 by Van Hedge Fund Advisors International, LLC and/or its licensors, Nashville, TN, USA. Table represents estimates only. Please see Explanatory Notes under Legal Considerations section.

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Global Hedge Fund Net Returns January 1, 1988 June 30, 2004 Style/Strategy Net Compound Annual Return Standard Deviation Van Ratio Sharpe Ratio

Van Global Hedge Fund Index

15.6%

8.6%

3.5%

1.6

Look at the Sharpe Ratios

MSCI World Equity

6.2%

16.2%

35.1%

0.4

S&P 500

12.3%

15.3%

21.1%

0.7

Morningstar Average Equity Mutual Fund

9.8%

15.8%

26.7%

0.6

Lehman Brothers Aggregate Bond Index

8.1%

4.4%

3.4%

1.4

2004 by Van Hedge Fund Advisors International, LLC and/or its licensors, Nashville, TN, USA, (615) 377-2949. Please see Explanatory Notes under Legal Considerations section.

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Correlation to Lehman Government/Credit

Rolling Correlation Leh Gov/HFR Fund of Funds 0.30 0.20 0.10 0.00 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 -0.10 -0.20 -0.30 -0.40 -0.50 Rolling Correlation Leh Gov/HFR Fund of Funds Sep-03

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Recent Performance of Hedge Funds

dd Convertible Arbitrage - 8.5% ca Dedicated Short - 1.5% ff Emerging Markets - 3.4% 97 Equity Mrkt Neutral - 7.8% 21 Event Driven - 12.2%

86 Fixed Income Arb - 14.0% 54 Global Macro - 15.3% ec Long/Short Equity - 15.8% da Managed Futures - 9.3% 11 Multi-Strategy - 12.2%

Data as of August 31, 2004 Click on an index for thorough statistical analysis, sector commentaries, and constituent fund listings.

Index CSFB/Tremont Investable Index INVX Convertible Arbitrage INVX Dedicated Short Bias INVX Emerging Markets INVX Equity Market Neutral INVX Event Driven INVX Fixed Income Arbitrage INVX Global Macro INVX Long/Short Equity INVX Managed Futures INVX Multi-Strategy

Value 104.38 106.81 89.24 118.16 102.43 108.68 103.57 106.41 107.27 93.73 101.99

Aug 04 -0.34% 0.18% 2.14% 2.07% 0.27% -0.00% -1.01% -1.43% -0.32% -1.13% 0.31%

YTD 0.46% 1.51% 5.60% 5.42% 1.08% 2.40% 3.89% 1.17% -0.82% -9.76% 1.56%

1 Year 3.75% 8.19% -9.22% 15.00% 2.38% 7.81% 2.99% 5.87% 5.39% -8.13% 2.14%

Avg Annl* Std Dev** Sharpe*** 7.80% 12.87% -1.20% 16.80% 6.49% 9.34% 7.58% 10.81% 0.94% 9.28% 8.40% 2.79% 3.53% 16.49% 8.53% 2.16% 2.93% 3.38% 4.31% 11.21% 13.74% 3.47% 1.81 2.86 -0.24 1.65 1.73 2.25 1.43 1.87 -0.16 0.48 1.63

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SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

CFSB/Tremont Statistics
Statistics Avg Month Best Month Worst Month Mth Std Dev Mth Std Dev, Ann'd Beta(vs S&P 500) Sharpe CSFB/Tremont Hedge Fund Index 0.88% 8.53% -7.55% Risk Free 0.32% 0.51% 0.07% MSCI World $ 0.67% 9.06%

(13.32%) 2.38% 0.14% 4.15% 8.25% 0.48% 14.37% 0.26 0.00 0.86 0.82 0.00 0.23

CSFB/Tremont MSCI Risk Hedge Fund World Free Index $ Dow 0.40 0.07 0.89 MSCI World $ 0.47 0.01 1.00 MSCI EAFE $ 0.41 -0.06 0.94 S&P 500 Total Return 0.48 0.09 0.94 NASDAQ 0.53 0.02 0.78 Correlations

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Insurance Company Investments in Hedge Funds

Why do we not see more insurance companies embracing hedge funds. Capital costs. Perception issues. Ability to evaluate hedge funds. It is outsourcing the investment department4. Scalability of hedge funds. Lack of transparency by hedge funds. Its just too different. With time, these issues will be worked though.

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In the future, the investment process gets divided into beta and alphaindependent but connected.
Duration Factory Uses Swaps and futures to Manage ALM
Optionality Annex

Alpha Factory. Credit default swaps, option writing, hedge funds to get spread

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In the future, the investment process gets divided into beta and alphaindependent but connected.
Why does this help? Focus on what is value added. Clears up performance attribution issues. Actually, in an environment of premium bonds, minimizes credit risk in a default. More targeted risk management. If the CMBS team buys a single tenant building deal on XYZ and the corporate bond team has exposure to XYZ then risks can easily be managed. Expands the opportunity set, increases your chances for success.
IR=IC * SQRT(Breadth)

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Organization

Duration factory Manages the net duration position of the firm using futures, and swaps.
Futures and swaps require little cash outlay.

Manages duration globally across the firm or across a product line. Manages spread duration and rate duration.

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Organization

Alpha factory Invests the cash in products that earn alpha. Hedge funds Sells options-Synthetic Mortgages. Credit default swaps Bonds,Mortgages etc. but emphasis would be to bifurcate spread risk from rate risk.

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Organization

Options Annex Insurers find themselves long and short options. The industry has learned that these options have value.
Minimum Crediting Rates VA Guarantees Mortgage Backed Securities

Across a firm, these options may offset or increase other risks.

VA Guarantees versus equity linked annuities.

How many insurers can compute what they have earned by being short equity and interest rate vega?
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Sizing trade How much do we put in hedge funds? Sell 100mm Gic looking to earn 200 bps How much extra capital needs to be put up?

Duration

Hedge Fund Portfolio Expected Return 10%

20% into hedge funds

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Challenges

Factory Manger-Who runs the alpha factory.

CIO Risk Manager Soviet style committee

How does risk get allocated? This does appear to be an ideal set up for risk budgeting.
Analysts and PM get assigned a risk budget.

Deciding on an appropriate time horizon.

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Challenges

Systems- You need to build those pipes, and they have to run all the time and handle everything. GAAP Accounting- Pesky rules that may require different timing on gains versus payments to insured. STAT Accounting. How do we get the regulators on board? RBC What is the RBC on a hedge fund? What should it be? Risk management- What are the risks -credit, equity, vega and others that the underlying manager owns or is short.? Taxes.

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Goals for the Next Generation

How risk is packaged should not be an issue to prevent investments by an insurance company.
Securities are bundles of risk.

Insurance company should have the ability to measure and manage risk in all forms. Hedge funds are an investment vehicle for investing outside of regulated firms. The ability to see into hedge funds there risks, should allow insurance companies to get comfortable in investing in hedge funds.

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Summary

In the last decade, with little fanfare, the ability to bifurcate interest rate risk from credit risk has become a reality. Rather than match assets with liabilities, an alternative would be to bifurcate assets and liabilities into treasury rates (beta, spreads (alpha) and optionality. This will decrease risk to the insurer, place a clear focus on value added by the investment department, and should increase the opportunity set. Hedge funds provide a format to obtain pure alpha in a variety of strategies non-correlated with traditional investments. Total separation will take time as firms work through a host of regulatory, and legal issues.
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Contact Information

Matt Halperin,CFA Mhalperin@spycap.com Spyglass Capital (239)594-2747 (508)269-3942 (Cell)

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Disclaimers
CSFB/Tremont Index Data Index data begins January 1994. Sharpe ratio calculated using a rolling 90-Day T-bill rate. There data is subject to the following note: 1999 - 2003 Credit Suisse First Boston/Tremont Index LLC. All rights reserved. This communication is for informational purposes only. It is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument. No market data or other information is warranted by Credit Suisse First Boston/Tremont Index LLC or its subsidiaries and affiliates as to completeness or accuracy, express or implied, and is subject to change without notice. Any comments or statements made herein do not necessarily reflect those of Credit Suisse First Boston or Tremont Capital Management Inc., or any of its or their respective parent entities, affiliates or subsidiaries, or any officer or employee thereof; Credit Suisse First Boston, Tremont Capital Management Inc., and/or its or their respective parent entities, affiliates or subsidiaries, and/or officers or employees thereof, may have issued other communications that are inconsistent with, or reach different conclusions from, the information presented herein. Those communications reflect the assumptions, views, and analytical methods of the persons that prepared them.

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Hedge Funds Returns What is Portable Alpha

David Hopewell Ernst & Young SOA October 25, 2004

Learning Objectives
Recognize the meaning of alpha and beta in the context of hedge fund return analysis. Understand how statistical techniques are used to estimate alpha and beta. Identify some non-linear investment strategies that can be used to refine estimates of alpha and beta. Identify the term beta stacking and how it can be relevant to analyses of alpha.

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

What is Alpha?
E(Returnt)= +rt+ 1X1t + 2X2t ++t 1. 2. 3. 4. 5. 6. Rt is a short term rate like 3M LIBOR X1t is the change in market factor 1 at time t 1 is the sensitivity of expected returns change in index 1, and t is the time dependent uncertainty of the expected return on the factors, and is the over or underperformance relative to the market risks taken Least square regression should be used cautiously, as unidentified, non-linear factors are likely to be present.

How is Alpha used?

As a high return substitute for cash. As the basis for overwriting other risks that finance on a LIBOR basis. Examples in the mutual fund world have names like Stocks Plus and Double Real.

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

What is Alpha, again?

The estimate of alpha depends on which market factors are included in the estimate. One selling point of hedge funds is exposure to new market factors How can we distinguish between true alpha and new/unusual market factors?

Engineering Returns
Many return patterns can be constructed from basic assets and a trading strategy. One part of the hedge fund value proposition is skill in determining which combinations of return patterns, instruments, and strategies are most lucrative.

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Once I find it, its Beta

Market Factors go beyond the capture of equity and bond returns.
New risks, like catastrophe bonds Higher moments of the price distribution Volatility Skew Kurtosis Non-linear correlations

Case Study
Global Macro Fund Allocates between stocks, bonds and currencies. Trading strategy based on quantifying lagged effects of shifts in economic fundamentals and government policy.

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Estimating Alpha - Step 1

Against Equity

Coefficients Standard Error t Stat P-value Alpha 0.0215 0.0050 4.3228 0.0001 Beta 0.0724 0.0912 0.7935 0.4306

Against 7-10 yr. government bonds

Coefficients Standard Error t Stat P-value Alpha 0.0232 0.0047 4.9674 0.0000 Beta -0.7215 0.3233 -2.2321 0.0295

Step 2 Create a custom index

Short large cap, long mid cap Short bills, long bonds

Alpha Beta

Coefficients Standard Error t Stat P-value 0.0259 0.0051 5.1040 0.0000 0.3058 0.1219 2.5090 0.0149

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Step 3 Nonlinear analysis

Fund strategy is to capture the maximum difference between available asset classes Returns should look like a spread option

Alpha Beta

Coefficients Standard Error t Stat P-value -0.0062 0.0075 -0.8209 0.4150 0.3908 0.0875 4.4641 0.0000

Capturing Moments
First moment returns can be captured by comparing fund returns to total returns. Second moment returns can be captured by looking at the return on straddles. Third moment returns are captured by the return on risk reversals. Fourth moment returns are captured by the return on strangles.

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies

Capturing Changes in Correlation

Changes in correlation can be captured by multiple asset options like spread options. Stocks vs. indexes - the dispersion trade - is a correlation. Yield curve shape changes can be thought of as correlation changes.

Whither Alpha?
In many cases, alpha isnt an excess return. Observed alphas are often examples of beta stacking. Exposure to custom indexes and non-linear payoffs may be a good investment, but isnt really alpha. True alpha is rare and when discovered starts to become another market risk

SOA 2004 New York Annual Meeting - 83PD, Hedge Fund Strategies