abc hedge funds_eng

Alpha, Beta and Carry: The ABCs of hedge fund investing

December 2010

The views and strategies discussed in this paper may not be suitable for all investors. This information is provided for informational purposes and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Please read the important information at the end of this paper.

J.P. Morgan Global AccessSeeking the optimal hedge fund portfolioThe ABCs represent three critical elements that form the building blocks of the multi-trillion dollar hedge fund industry. Our goal is to tell you how these elements, together with other factors, influence the Global Access team’s investment strategy for building an optimal fund of hedge funds portfolio.

Richard MadiganChief Investment OfficerJ.P. Morgan Global Access

To make a truly informed investment decision, an investor needs to understand how a hedge fund actually generates returns — how well does a manager: exploit opportunities over other market participants (generate alpha); manage and profit from exposure to market risks (beta); enhance returns through exposures to alternative systematic risks that do not exist in traditional buy-and-hold portfolios (carry). The Global Access team refers to these elements as our ABCs of hedge fund investing.

With senior investment teams across New York, London and Hong Kong, and more than $11 billion in assets under management,1 the Global Access team is able to develop and leverage some of the most innovative and interesting investment strategies for our clients. We also leverage an institutional due diligence team and process that helps us find the best and brightest managers to employ in our portfolios.

Hedge funds are fundamental in the suite of investment tools we use. While that’s an obvious statement for our fund of hedge funds portfolios, it’s equally relevant for our global multi-asset class portfolios.

We don’t believe hedge funds should be the only solution when it comes to investing. Liquidity plays an important part in any comprehensive investment strategy. But hedge funds remain an essential source of alpha because they have a far broader investment palette to draw upon, whether that includes long/short, distressed, relative value, arbitrage or macro strategies.

We think it’s important to lay out some of the subtle complexities of investing in hedge funds today. Also, we would like to put a framework around how we go about building a portfolio of hedge funds. We’ve developed what we believe to be a unique and proprietary investment approach to help us manage around what remains a particularly challenging market environment — but one filled with investment opportunity.

I hope you find this a valuable piece in our continued investment dialogue with you.

1 AUM data as of December 2010.

Alpha, Beta and Carry: The ABCs of hedge fund investing 1

The first hedge fund was launched in 1949.2 Over the past six decades hedge funds have evolved and grown into a global multi-trillion dollar industry. To understand where the industry is today, why we believe hedge funds should play a strategic role in most portfolios, and the complex analytic tools and strategies we employ at J.P. Morgan, it’s helpful to take a brief look at the sector’s earliest days.

A hedge fund is born

In 1949, A.W. Jones wrote an article, “Fashions in Forecasting” for Fortune magazine after a small personal investment in a stock research company piqued his interest in technical market analysis.

Jones was a man of diverse interests. A 1924 Harvard graduate, he also held a Ph.D. in sociology from Columbia, was a former cargo ship worker, member of the U.S. Foreign Service and, later, an observer for Quaker relief efforts during the Spanish Civil War. He went on to establish the first hedge fund in 1949.

Early on, Jones learned that consistently forecasting the stock market was too difficult. His now-legendary innovation was to hedge market movements through short positions in stocks, and then to magnify the returns of this less risky portfolio through leverage. He formed his fund as a private partnership and made it unique by using the new hedging technique. His innovative investment style was very successful and soon others were eager to invest with him. In 1952, Jones offered some investors a limited partnership in the fund, but with conditions. They would only be allowed to invest in, or redeem from, the fund at the end of each fiscal year so that his trading would not be constrained by his clients’ cash flows. In addition, they would have to give one-fifth of their investment profits to the managing partners as a performance fee,3 a concept already being used by other private investment partnerships at the time.

Jones created a powerful new type of investment vehicle by effectively combining hedging, leverage, investor liquidity, and performance fees. These remain the defining characteristics of hedge funds today.

Despite the revolutionary nature of Jones’ offering, the hedge fund industry grew slowly over the following years. This changed in 1966 when Carol Loomis wrote an article for Fortune magazine titled “The Jones Nobody Keeps Up With” in which she highlighted how the “hedge fund” had outperformed even the best mutual funds in the previous 10 years.

By the start of the 1990s, about 500 hedge funds with approximately $50 billion in total assets were in operation. The industry’s growth compounded after they out-performed the stock market between 2000 and 2003. At its peak in late 2007, the hedge fund industry had grown to more than $2.8 trillion in assets.4

2 Source: International Monetary Fund, Economic Issues No. 19. “Hedge Funds: What Do We Really Know?”3 A.W. Jones was said to have been inspired by sea captains citing that in Medieval Europe, when Venetian merchants returned from a successful voyage, they took 20% of the profits from their patrons. In fact, profit shares of one quarter or more were common in those days. In the ancient world, Phoenician ship captains kept a share of the profits from their voyages as did sea merchants, captains, and explorers throughout history. When Magellan made his famous voyage, King Charles issued a contract whereby Magellan and his partner were to receive 5% of the revenues from their discovered lands, and a 20% share of profits from the cargo of their first voyage. A fee arrangement commonly used by many hedge funds today.4 Source: HFN Hedge Fund Industry Asset Flow/Performance Report Q4 2009.

2 Alpha, Beta and Carry: The ABCs of hedge fund investing

GRowth of the hedGe fund industRy

As the hedge fund industry grew, so did the level of complexity. Ongoing innovation, entry into new markets and creative trading strategies made it more and more difficult for investors to understand what exactly hedge funds were doing.

Add to the mix heightened levels of competition, and it was becoming increasingly difficult for investors to choose the best managers. Then, as the industry evolved into an integral part of the investment universe, it also became more susceptible to systematic shocks in the financial markets.

Growing investor uneasiness, which intensified after the collapse of Amaranth Advisors in 2006, was further exacerbated by the Bernard Madoff Ponzi scheme. In different ways, each of these events highlighted how easily a hedge fund could hide its problems and exploit investors’ lack of familiarity with complex trading strategies and limited information. These issues came to the forefront during the 2008 financial crisis. In spite of these challenges, the hedge fund model remains as convincing today as it was in Jones’ heyday with its ongoing ability to manage risk and add returns in a portfolio. However, given the complexities of today’s global markets, successful hedge fund investing requires increasingly sophisticated decision-making — as well as the careful selection of not one fund, but a combination of different types of funds as part of a well-diversified portfolio.

This paper discusses the complexity of hedge funds, including: the factors that can impact their performance; a look at the three major sources of returns — what we refer to as the ABCs (Alpha, Beta, Carry); the industry’s underlying economics; and what additional information we need to gather, analyze and understand in an effort to create an optimal portfolio of hedge fund investments.

Source: HFN Hedge Fund Industry Asset Flow/Performance Report Q4 2009.

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the ABCs of hedge funds returns

To better understand hedge funds, we need to know how they really generate returns. There are three ways for investors to earn returns that are above average risk-free rates.5

They can earn a premium for taking on risks that cannot be diversified away. These can be either:

1. Easily accessible systematic risks derived from directional market exposures (beta)

2. Alternative systematic risks, which require skill to access (carry)

Or, investors can:

3. Exploit an advantage over other participants in the financial markets (competitive edge — alpha)

The Global Access team considers the systematic risks and competitive edges underlying hedge fund returns in the context of these main categories, or sources of return. Our dedicated team of quantitative experts drives this cutting edge approach to hedge fund investing.

We begin our discussion with the more straightforward driver of hedge fund returns, beta.

Market beta — exposure to the systematic risks in publicly traded markets such as stocks, bonds and commodities — is one of the major sources of returns for hedge funds. These are the same sources of returns in a traditional buy-and-hold portfolio of stocks and bonds. So, why are hedge funds exposed to beta if they are supposed to be a source of alternative returns?

The main reason is because hedge funds want to take an active view on directional risks. Many funds, such as long/short equity funds, have a strategic view to be long on markets because they believe risk assets6 will go up in the long term. This concept was already evident in the very first hedge fund as A.W. Jones always maintained an overall net long exposure to equity markets. Others take more tactical views based on their current understanding of the macroeconomic environment.

Carry strategies allow hedge funds to earn returns through exposures to alternative systematic risks that do not exist in traditional buy-and-hold portfolios. Some alternative risks are the result of creating spread positions between liquid securities through offsetting long and short positions. For example, global macro funds often reflect the flattening or steepening of the yield curve by trading offsetting positions in 2-year and 10-year bonds.

Another common source of hedge funds’ profits is to be paid for taking on exposures to large downside risks. Understandably, investors want to avoid major losses during a large, unexpected drop in the stock market, and are prepared to

5 The theoretical rate of return for an investment that has zero risk over a specified period of time. In practice even the safest investments carry a small amount of risk. The interest rate on a three-month U.S. Treasury bill often is used as the risk-free rate.6 Risk assets defined as assets subject to change in value due to changes in market conditions or changes in credit quality, interest rates, or various repricing opportunities.


pay a premium to do so. High demand from investors leads financial instruments that seek to provide portfolio protection to be priced at a premium over their economic value. Hedge funds that consistently sell put options and hold them until maturity will collect this premium over time, as they will with any investment that has an embedded large downside risk.

Hedge funds can also earn a premium for holding assets that are hard to buy and sell. Owners of illiquid assets cannot easily optimize the timing of their investments; consequently, these assets are usually priced at a discount to their fundamental value. Many hedge fund strategies exploit this illiquidity premium: a common example is to buy convertible bonds that are relatively illiquid, and to hedge out their other economic risks with liquid instruments such as stocks and derivatives.

Hedge funds can also potentially profit from risks associated with an anticipated but uncertain event. For example, a company’s value may be contingent on a bankruptcy court decision or the board approval for a merger agreement (see chart below). These types of uncertainties are distinct from usual market economic factors, and therefore, may offer an alternative source of returns.

how event Risks ARe distinCt fRoM MARket Risks — timeline of cash acquisition deal7

These alternative returns can be collectively called carry, as they all involve collecting a risk premium while holding positions that do not have directional market exposure. Hedge funds are in a unique position to benefit from carry returns — first and foremost, because they have the expertise to execute these strategies that others do not. Furthermore, many other market participants are hesitant, unwilling or unable to accept the associated risk exposure.

Source: Bloomberg. For illustrative purposes only. Indices are not investment products and may not be considered for investment. The inclusion of the securities mentioned above is not to be interpreted as recommendations to buy or sell.

7 Source: Bloomberg. February 17, 2004, Cingular announces it will acquire AT&T Wireless for $15 a share in cash subject to approval of shareholders, the FCC and antitrust regulators. The acquisition closed on October 26, 2004.

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Cingular acquisition of At&t wireless (Awe)stock price of Awe versus s&P 500 index Pre-Announcement through Closing


Hedge funds are also uniquely positioned to generate returns through leverage. Unlike mutual funds, hedge funds are able to borrow money to invest in large positions. This is especially useful for carry trades, which typically generate small returns relative to the amount of cash invested.

Ultimately, hedge funds are one of the best ways for an individual investor to access carry returns.

Hedge funds also seek to generate returns by using their skills to exploit advantages over other financial market participants — technically called alpha — the most complex source of hedge fund returns. The most common way for a hedge fund to gain a competitive edge is to invest in research. Typically, long/short equity funds employ a team of experienced analysts that conduct in-depth research on stock valuations in an effort to uncover pricing anomalies. Similarly, quantitative funds invest in hiring Ph.D.’s to search for profitable statistical patterns in the market.

Hedge funds also use their managers’ innate trading and portfolio management skills in an effort to generate profits. Hedge fund managers who can consistently demonstrate this skill over a long period of time are hard to find. However, hedge funds often have advantages in attracting this type of investment talent.

Major types of hedge funds

description Beta Carry Alpha

Long/Short Equity

Trade long and short positions in stocks

Equities Equity Spreads

Stock Valuations

Event Driven

Exploit pricing inefficiencies caused by anticipated specific corporate events

Equities and Bonds

Event Risk, Illiquidity Risk

Corporate Action Probability

Global Macro

Time exposures to global markets using price patterns and macroeconomic forecasts

Equities, Bonds, Currencies and Commodities

Calendar and Country Spreads, Skew Risk

Economic Research, Trading Skills

Credit RelativeValue

Trade offsetting positions in bonds and derivatives

Bonds Illiquidity Risk, Bond Spreads

Bond Valuations

Source: JPMorgan.

is Beta exposure timing A source of Alpha or Beta?

The answer depends on the investment horizon, as illustrated by this graph of a hypothetical fund that decides to go long or short the S&P 500 at the beginning of every week:

1. Within a given week, the fund definitely has beta exposure.

2. But an investor typically has a lock-up period of months.

3. From the investor’s perspective, the performance of the fund can be attributed to alpha, since there is little correlation to the market over the investment horizon.

4. However, if the beta timing is slower than the investment horizon, the exposure becomes simply beta.

By and large, beta timing is a source of alpha generation because of the liquidity profile of hedge funds. If investors evaluate and can invest and redeem from the fund from week to week, they may attribute

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Source: JPMorgan. For illustrative purposes only.

to beta some of the returns that the hedge fund derives from its timing decisions. In individual weeks, investors may see a strong correlation to the market. However if they look at the

timing decisions over a longer time horizon — and consider the normal liquidity constraints of hedge funds — they would attribute the fund’s return to alpha.


investigating the performance of individual hedge funds

Combining the best available sources of information about hedge funds with knowledge of the underlying economics of the industry is a key first step in the process for constructing a portfolio of hedge fund investments.

Not surprisingly, there are a number of challenges to determining a fund’s investment profile. To safeguard their competitive edge and sources of alpha, hedge fund managers are often reluctant to disclose detailed information. In addition, hedge funds change their investment allocations and trading strategies over time, so understanding what happened in the past is not necessarily indicative of the future.

However, there are useful qualitative and quantitative sources of information available to investors; in both instances, the work of analyzing this data should be done by a financial professional who has the appropriate training and background to decipher the often limited, complex and obscure information on a fund. J.P. Morgan relies upon the expertise of a dedicated alternative manager due diligence team to screen the universe of potential hedge funds and identify best-in-class managers. Once potential and appropriate managers have been identified through the due diligence process, the J.P. Morgan Global Access team evaluates them to determine their suitability for our portfolios. When evaluating hedge fund managers, we do not look at them simply as individual funds, we evaluate them in the context of how their monthly performance impacts overall portfolio construction and risk.

We begin our due diligence by analyzing monthly returns. This is the most common and reliable source of data available because the returns are audited and frequently produced by a third-party fund administrator. Moreover, these returns are often an initial indication of the fund’s performance and suitability for investment.

Our next step is to review a summary of the hedge fund’s holdings. Increasingly, hedge funds report position information through third-party companies, such as Measurisk and Riskmetrics. This has improved the reliability and consistency of position reporting, but not yet to the point where it can consistently or solely be relied upon for fund analysis.

We also obtain qualitative information about a fund’s trading activities. Our experienced professionals view the data through the lens of the fund’s stated trading strategies and the prevailing market environment. From this analysis, we can make a proper assessment of how a fund generates its returns, and more importantly, assess whether this performance can be sustained in the future.

Our due diligence team’s investigation of each manager includes background checks on the management team, site visits and reference checks — all of which are designed to uncover potential problems. Simply stated, due diligence is the only way to uncover hidden operational risks or other vulnerabilities that could result in unexpected losses to investors. To that end, J.P. Morgan’s experts thoroughly evaluate everything from the technology infrastructure, compliance procedures and risk policies, to the funds’ accounting methods and where they custody assets.


Our due diligence procedures don’t end when a fund has been selected and approved for investment. We conduct ongoing checks in an effort to ensure that the fund continues to conduct business appropriately and to detect any significant changes in how it operates.

the importance of factor analysis

usinG the GloBAl ACCess PRoPRietARy fACtoR Model to CReAte hedGe fund PoRtfolios

In addition to using all of the available sources of information about each fund, an equally critical component for the investment process is the use of the best available quantitative methods.

Factor analysis, an important quantitative technique for analyzing financial investments, plays a key role in both our fund selection and portfolio construction strategies. This tool uses statistics to analyze the funds’ monthly performance. The underlying assumption of a factor model is that a hedge fund’s returns can be described as a combination of exposures to common factors, such as the S&P 500 or interest rates. The first step in using a factor model is to decide exactly which factors to use. For our proprietary factor model, the Global Access team has carefully analyzed and chosen factors (see Appendix for a discussion of this process). However, the model does not presume that all returns are described by these exposures, some portion of the returns are specific to each particular hedge fund and are attributed to alpha.

To use factor analysis in hedge fund portfolio construction, it’s important to measure sources of risk and return other than just market beta. Ideally, all sources of returns should be incorporated into a model so that carry and alpha can be properly measured.

One possible way to incorporate sources of returns into a factor model is by using published indices that are based on the average return of hedge funds in a certain style of investing, for example, the Hedge Fund Research Inc. (“HFRI”) Macro or Event Driven indices. However, hedge funds are not required to make their returns publicly available, so typically only hedge funds that are trying to gather new assets are willing to self report to the indices.

In addition to this selection bias, the indices only use the returns of currently operating funds and the prior history of successfully launched funds, so there is also survivorship bias. In any case, the activities of the underlying hedge funds are not well known, so the portfolio sensitivities to hedge fund indices are of little meaning since they are impossible to forecast or replicate.

We have found that a more promising approach is to use factors that explicitly represent carry risks. These are created by replicating the most common trading strategies of hedge funds. For example, a widely used strategy among Event Driven funds is to invest with a view on the probability that pending company mergers will succeed by buying or selling the stocks of the companies involved. This tactic creates a factor that represents the systematic carry risks in these strategies. Once beta and carry risks have been properly measured, the residual alpha risks can then be easily determined.


The Global Access team believes a well selected factor model that includes both replicating style factors to estimate carry, as well as traditional market factors to estimate beta, offers a valuable and comprehensive analysis of hedge fund returns.

fRoM theoRy to APPliCAtion

An excellent example of the value of a well selected factor model is illustrated by the anomalous behavior of hedge funds during Lehman Brothers’ collapse in late 2008. Before the meltdown, hedge funds were perceived as vehicles for preserving capital during market downturns. In 2008, by contrast, hedge funds suffered along with markets in the sell-off during the fall.

While in reality, there are numerous complex issues involved, we can apply a simple factor analysis to provide a framework to explain what happened.

To illustrate the point we analyzed the average returns of the hedge fund industry during the dot-com bust and the Lehman Brothers crisis, using a factor model with beta and carry factors.

The model shows that during both periods, the hedge fund industry had a similar risk exposure to beta and carry, but an attribution of the hedge fund returns shows why the outcomes were different.

In the analysis, the HFRI Fund Weighted Composite Index8 is used to represent the hedge fund industry’s performance overall. From the end of March 2000 through September 2002, the MSCI World index declined almost 50%, while the HFRI avoided such losses, and was roughly flat over the same period. However, in September, October and November 2008, when the MSCI World declined 33%, the HFRI fell -15%.

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Source: JPMorgan and Bloomberg. For illustrative purposes only. Indices are not investment products and may not be considered for investment. Past performance is no guarantee of future results.

8 This index is calculated by taking the equally weighted average of all available hedge fund returns, and provides a broad representation of the performance of the hedge fund industry.

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dot-Com Bust lehman Brothers Crisis

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lehman Brothers Crisis

hedge fund Returns during Market downturns


As expected, beta was a detractor of returns in both periods of market difficulty. However, despite the overall losses in the hedge fund industry, the beta losses during the Lehman Brothers crisis were not remarkable compared with the previous downturn. Also, alpha was positive during the Lehman Brothers crisis, just as it was during the dot-com bust. The major difference between the two periods was in the carry component.

While carry was a major positive contributor of returns during the dot-com bust, it was an additional source of losses during the Lehman Brothers crisis. This is because the Lehman Brothers collapse took place amidst a liquidity crisis in addition to a market crisis. Since many of the carry strategies that hedge funds profit from are associated directly, or indirectly, with market liquidity, they performed poorly.

The above discussion illustrates how factor analysis can be a valuable tool for combining information on market conditions, as well as hedge fund performance, in a comprehensive way. We believe factor analysis supported by qualitative and quantitative methods of due diligence should all be used when building a portfolio of hedge fund investments.

the Global Access approach to portfolio construction

To put it simply, our goal is to maximize returns while minimizing risks. We generally focus on two types of risks: month-to-month variations in returns and the risk of a large loss. The month-to-month variation is commonly measured by the volatility of returns, while the risk of a large loss is harder to measure and requires elaborate stress testing to quantify since it occurs relatively infrequently.

Since hedge funds are valued as an alternative source of returns, an additional objective is to have a low correlation to more common sources of returns, such as the stock market, so that a multi-asset class portfolio will have diversified risks. Also, given the restricted liquidity of hedge fund investments, careful consideration must be given to the overall liquidity profile of the combined portfolio.

An optimal portfolio contains a collection of hedge funds that will maximize returns, minimize risk characteristics and satisfy liquidity requirements. We seek to accomplish this through four key elements of fund of hedge funds portfolio construction:

1. Conviction in a manager’s ability to consistently generate alpha through a deep understanding of that manager’s investment strategy

2. Diversification of the ABCs 3. Concentration of investments4. Maintaining liquidity to stay dynamic

Source: JPMorgan and Bloomberg. Past performance is no guarantee of future results. Dot-Com Bust defined as end of March 2000 through September 2002 and Lehman Brothers Crisis tracked through September, October, and November 2008.

Index Return HFRI Attribution

MSCI HFRI Alpha Beta Carry

dot-Com Bust -47% -2% 8% -20% 10%

lehman Brothers Crisis -33% -15% 3% -13% -5%


1. ConviCtion in MAnAGeR AlPhA While beta and carry returns are easier to access, alpha is difficult to find and requires careful fund selection.

Any analysis of a particular fund requires all of the available quantitative and qualitative information obtained through rigorous due diligence. We leverage this information to form a forward-looking view of the fund’s ability to generate alpha.

This not only requires a deep understanding of how the fund generates returns, but also a view on how the market environment will affect those returns in the future.

2. diveRsifiCAtion of the ABCsOnce we’ve identified what we believe to be the best funds, our next step is to find the optimal way to combine them into a portfolio. Again, this requires a combination of qualitative and quantitative methods to maximize the risk diversification within the ABC allocations. Each component of the Global Access ABC framework plays a unique role in achieving portfolio goals.

Alpha is idiosyncratic to each fund, has low correlations to the markets, and typically offers returns with low volatility. However, good alpha is difficult to access because it is concentrated in only the highest quality funds.

Conversely, beta is readily accessible, but is more volatile and represents the portion of hedge fund returns that are correlated with other markets.

Carry returns are less volatile than traditional beta returns, but they have smaller expected returns, large drawdowns, tend to be less liquid and are more difficult to access. They nevertheless are valuable because carry offers more reliable returns that are uncorrelated with the markets.

Since none of these three sources of returns satisfy all the portfolio objectives on their own, the portfolio should include each. Further diversification can then be achieved within each of the three categories.

GloBAl ACCess hedGe fund stRAteGies tARGet Risk AlloCAtions

Source: JPMorgan. As of December 2010. For illustrative purposes only.

Alpha30%

Carry30%

Beta40%


Potential Returns

volatility

drawdown

Correlation

Alpha Moderate Low Moderate Low

Beta High High High High

Carry Moderate Low High Low

The most common way to diversify within the three categories is by major styles of investing, such as long/short equity or global macro, which naturally have different risk exposures (see Appendix). This method captures the broad themes of hedge fund investing and is easy to implement.

We believe each of the major styles of hedge fund investing should be represented in a portfolio to ensure a basic level of diversification. However, there are pitfalls. Many hedge funds do not easily fit into one style category, so the classification decision can become arbitrary. Moreover, there is a lot of overlap between the risk characteristics, so the true level of diversification is hard to determine.

We believe a better approach is to directly address the underlying returns of the hedge funds through the use of quantitative and qualitative techniques. Diversification should then be determined by the individual funds’ exposure to alpha, beta and carry.

Although alpha represents the portion of hedge fund returns that are idiosyncratic to a fund, there are some common themes for alpha generation. For example, long/short equity funds typically generate alpha through stock research, while global macro funds generate alpha through economic research. A portfolio should be diversified between these alpha themes as well.

The most common directional betas in hedge fund portfolios are equity market risk and high yield bond risk. Interest rate risk and commodity risk are also very common. The exposure of each fund to these risks can be quantified using the factor model, and the overall exposure of the portfolio can then be estimated to determine the overall level of diversification.

We can also quantify many of the carry exposures using factor analysis. Exposures to typical spread risks, such as a bias to smaller cap stocks, or a steepening of the yield curve, are just as easy to quantify. Other alternative risks are harder to estimate, but can be approximated using asset-based factors.

Source: JPMorgan.


3. when less is MoRe …As funds are added to a portfolio, the total risks associated with the alpha portion of returns will diminish through diversification, but the beta and carry risks do not diversify away. In addition, as the number of funds in a portfolio increases, it becomes increasingly difficult to find alpha because of the limited availability and capacity of the highest quality funds. Therefore, as funds are added to a portfolio, diversification reduces the portfolio’s overall risk, but returns also decrease.

We’ve found that the risk declines sharply as the first 15 or 25 funds are added to a portfolio, but then quickly levels off and declines only marginally as more funds are added. Adding too many hedge funds simply reduces the efficiency of a portfolio as measured by the average return achieved per unit of risk.

It’s important to find the optimal combination of hedge funds that properly balances risk and returns. Less can be more, as the number of funds in a portfolio should be limited in order to favor the level of alpha. After a certain point, the alpha is diluted. As more funds are added, the common systematic risks dominate the portfolio.

This illustrates two key points about hedge fund portfolio construction that underlie the Global Access team’s approach. First, that diversification on the portfolio level cannot be fully understood by just style categories. Portfolio diversification must also be understood by the parameters of the alpha, beta and carry of each fund.

Second, the number of funds in a portfolio is an important parameter that has a direct impact on portfolio risk and return characteristics. The larger the number of


when less is More … illustrative Mathematical Assumptions

Assume you have 100 hedge funds from which to select a fund portfolio. Each hedge fund has an identical risk profile that consists of a small amount of a common systematic beta or carry risk, and a larger idiosyncratic alpha risk. However, since the quality of each fund varies, the expected alpha returns of the funds range from 15% to -5%.

exposure Risk Return Correlation

Alpha 1 10%15%

to -5% 0%

Beta & Carry 0.25 15% 10% 100%

Using this simplified model, it’s easy to determine how hedge funds are included in the portfolio. If the risks are the same, we select funds based solely on their expected return, and those funds with the highest returns are selected first.

Source: JPMorgan. For illustrative purposes only. There is no direct correlation between a hypothetical model and the actual model used.

0%10%20%30%40%50%60%70%80%90%

100%

Alpha RiskBeta & Carry Risk

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

0%2%4%6%8%

10%12%14%16%18%20%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Risk

and

Ret

urn

Number of Funds

Ratio

Annualized Return Annualized Volatility Ratio

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100


funds, the greater likelihood that risk becomes dominated by systematic exposures and that returns converge to the industry average.

We generally limit our portfolios to 15 to 25 funds, ensuring diversification without dilution of alpha. We believe this is the optimal number of funds to implement our view of the current investment cycle.

At the same time, in order to defend against tail risks, especially idiosyncratic risk, we control our investment bite size. We generally have limits of 5-6% for single strategy managers, and 10-15% for diversified managers.

4. MAintAininG liquidity to stAy dynAMiCLiquidity management is also critical. We manage our portfolios to generally have 70% or greater liquidity on a quarterly basis. This is important because we actively rotate managers and particular strategies based upon our market views and the current investment cycle. Hedge fund replication strategies that track overall industry performance using liquid instruments can also be used to help manage portfolio liquidity.

However, the liquidity terms of a specific hedge fund, such as the lock-up period, need to match the liquidity of the fund’s holdings. Just as A.W. Jones realized when he created the first hedge fund, a fund invested in less-liquid securities or strategies must match its liquidity (the lock-up of capital for investors) to the structure of the fund in order to avoid detracting from the fund’s performance.

Conclusion

A.W. Jones created the very first hedge fund in 1949. Remarkably, an operation begun by one man with $100,000 of capital has grown into a trillion-dollar industry.

The Global Access team uses a robust set of quantitative and qualitative tools to navigate what has become a more sophisticated, but also more complex investment environment. We also rely on a dedicated institutional due diligence team and process. Each allows us to be dynamic in our asset allocation, based around our macroeconomic views across global markets. Also, this approach allows us to manage more concentrated investments on a highest-conviction basis. Our ultimate goal is to maximize returns, minimize risk and guard liquidity in order to remain agile in the face of a particularly challenging investment environment — but one filled with investment opportunity.

For illustrative purposes only.

hedge fund ReplicationMany investment banks offer financial products that are designed to replicate the performance of hedge fund indices using liquid instruments. The main drivers of returns for these broad hedge fund indices are beta and carry as opposed to alpha. It is therefore possible to replicate a good portion of these returns with liquid instruments such as stocks, bonds and derivatives. But replication is not a substitute for manager alpha, which is ultimately why we are investing in hedge funds.

Annual10%

Monthly15%

quarterly75%

target liquidity Profile


fACtoR AnAlysis oveRviewThe statistical method of factor analysis was first developed by the English psychologist Charles Spearman in the early 1900’s. He noticed that students who excelled in one subject had a tendency to excel in other subjects as well. He was able to model this phenomenon by identifying intelligence as a common factor in a student’s test scores. In 1992, Economics Nobel Prize winner William Sharpe developed a factor analysis of mutual funds called Style Analysis that quickly became very popular in the investment industry. It describes mutual fund returns as a combination of exposures to different types of equities. Building on William Sharpe’s work, William Fung and David Hsieh began in 1997 to first apply factor analysis to hedge funds. Since then, factor analysis of hedge funds has continued to be an active area of research in academia.

The mathematical formula for factor analysis is:

R Fi = return of the hedge fund on month i

= the beta loading of the fund to factor k

R ki = the return of factor k on month i

= the consistent performance of the hedge funds that cannot be explained by the factors, does not change from month to month

= the residual return on month i, this is the variation in returns that cannot be explained by the model.

APPlyinG fACtoR AnAlysis to A PoRtfolio of hedGe fundsThe application of this model requires the factor returns to be specified and the loadings to these factors to be estimated using historical data. Using longer historical windows for estimation allows more factors to be effectively used because there is more information to discern exposures. However, hedge funds’ risk exposures evolve over time, so very long estimation windows will not reflect these changes and accurately represent the current exposures. Care must therefore be taken to design the model in an optimal way so that it can be used most effectively for portfolio construction. In particular, the following questions must be addressed:

1. What are the goals and objectives of the analysis? 2. Which factors should be included in the model?3. How will the factor loadings be estimated?

defininG GoAls And oBjeCtivesFor a factor model to be useful for the management of a portfolio of hedge funds the following objectives must be satisfied:

1. Fund level – It must be applicable on the single fund level so that each fund can be analyzed and its impact on the overall portfolio can be estimated. Other factor models, such as those used to replicate the overall hedge fund industry, do not necessarily require this.

2. Forward looking – It must be designed to make the best forward looking estimate of the portfolio’s behavior rather than just explain past returns. Unlike a model used primarily for Due Diligence, improving the predictive power of the model is more important than describing historical returns in detail.

3. Comprehensive – It must encompass all the major systematic risks to which the portfolio is exposed. Although the number of factors in the model may be effectively limited, it is essential that the most important ones are included.

4. Concise – The number of factors must be small enough to reasonably follow and manage. Ultimately portfolio managers must be able to take a view on the factors and be able to target an allocation to them.

ChoosinG fACtoRsIn reality there are a countless number of economic factors affecting the returns of hedge funds. Funds can invest in any financial market and use a wide array of trading styles. However, in order to satisfy the objectives of the model, it is important to select only a limited number of factors. From a business perspective, this is driven by the need for the model to be concise enough for the portfolio manager to follow, but also from a technical perspective it is important to limit the number of factors. When a limited amount of monthly returns of a fund are compared to a large number of factors, some sort of data mining technique must be used to compute the factor loadings. This inevitably leads to the overfitting of historical data, which diminishes the forecasting power of the model. Thus in order to improve the predictive power of the model it is also necessary to limit the number of factors to those deemed most important. These are some of the major factors affecting hedge fund returns that could be included in a model:

Appendix: estimating the alpha, beta and carry exposure of a hedge fund portfolio using factor analysis


Beta factors – These factor returns are easily obtained from various market indices:

Equity Risk Emerging Market Risk Credit RiskInterest Rates Commodity PricesCurrency RatesVolatility

Carry factors – Although less readily available than beta factors, there do exist alternative return indices that track many of these returns. Also, some carry factors can be represented through a simple combination of beta factors.

Equity Spreads – Non-directional equity risk can be represented by offsetting positions in different types of equities. The two most important attributes of stocks that determine their relative performance are widely believed to be their market capitalization and their value or growth style. Other important attributes are their price momentum, geographic region and industry sector.Fama, Eugene F. and Kenneth R. French. “The Cross-Section of Expected Stock Returns.” The Journal of Finance Volume 47, No. 2 (June 1992): 427-465.

Interest Rate Calendar Spreads – Exposure to changes in the slope of the yield curve can be represented by offsetting positions in bonds with different durations.

Volatility Arbitrage – A common hedge fund strategy is to exploit the overpricing of options. This can be represented by a factor that tracks the difference between implied and realized volatility through variance swaps.Bondarenko, Oleg. “Market Price of Variance Risk and Performance of Hedge Funds.” Working Paper, University of Illinois, Chicago March 2004.

Merger Arbitrage – Many of the risks in a merger arbitrage strategy can be represented by an index that holds all stocks that are currently involved in a pending merger.Mitchell, Mark and Todd Pulvino. “Characteristics of Risk and Return in Risk Arbitrage.” The Journal of Finance Volume 56, No. 6 (December 2001): 2135-2175.

FX Carry – This common Hedge Fund strategy can be replicated by an index that buys currencies with high interest rates and sells currencies with low interest rates.

Illiquidity – The amount of illiquid investments in a hedge fund can be estimated by the autocorrelation of its returns. In other words, the fund’s lagged returns can be used as a factor.Getmansky, Mila, Andrew W. Lo, and Igor Makarov. “An econometric model of serial correlation and illiquidity in hedge fund returns.” Journal of Financial Economics Volume 74 (July 2004): 529 – 609.

Beta timing factorMacro Trend – Many global macro funds, especially quantitative oriented ones, use the long-term trend of the major markets as a trading signal. Since this investment style is so common, a simple trend following rule can represent many of the returns of global macro funds. Fung, William and David A. Hsieh. “Survivorship Bias and Investment Style in the Returns of CTAs.” Journal of Portfolio Management Volume 24, No. 1 (1997): 30 – 41.

estiMAtinG fACtoR loAdinGsOnce a set of factors has been chosen, a method for estimating the factor loadings must be specified. The most common method is to use linear regression on a rolling window of monthly data. So, for example, the previous three years of monthly data is used to fit the hedge fund returns to the factors. These loadings are used only for the current month: for the next month a new trailing 36 months of returns is used to compute that month’s estimated current loadings. This method has the advantage of being relatively simple, yet still adaptive to changing factor exposures over time. However, this method requires the unrealistic assumption that factor loadings are constant over the whole estimation period, with the oldest month in the window having the same influence as the most current month. However, as the estimation window is shortened to make the model more adaptive the calculations become less robust. Also, a single month within the estimation period with extreme returns can easily skew the results. One way to improve the calculations is to remove these outliers in some cases. More importantly, a variety of regression techniques such as Weighted Least Squares Regression, or other more advanced statistical methods such as Kalman Filters and Neural Networks can be used to improve the accuracy of factor loading estimates with the same amount of historical data. However, care must be taken not to introduce model error through the calibration of new parameters and the use of data mining. Again, from the portfolio construction perspective, the utility of the model lies in its ability to forecast the future behavior of the portfolio.

inCoRPoRAtinG quAlitAtive dAtAAnother way to improve the factor loading estimates is to incorporate qualitative information into the model. Each hedge fund has a known investment style that will help determine to which factors the fund is exposed. For example, if a fund is known to only trade equities, it is unlikely to have a meaningful exposure to interest rates. Selecting a subset of factors for each style of hedge funds can help avoid spurious results and allows more factors to be included in the overall model.


defininG AlPhAFrom the portfolio construction perspective, alpha is the portion of portfolio returns that cannot be explained by the factors. More precisely, it is the portion of returns that cannot be reliably predicted by the model using historical data. Thus, this encompasses returns that come from unpredictable changes to factor exposures in addition to any returns that are unrelated to the factors included in the model. Forward-looking alpha is therefore quantified by comparing the actual returns of the fund with the historical monthly predictions that were made by the model using only the data available up to that time. Alpha is the tracking error between these two series of returns.

Risk exposures of hfRi hedge fund style indices — each has A unique Contribution to the Portfolio ABCs

Source: JPMorgan and HFRI. Data as of July 2010.

hfRi Relative value Credit hfRi event driven

hfRi equity hedge hfRi Global Macro

Equity22%

Fixed Income42%

Alpha11%

Carry25%

Macro Trend0%

Equity45%

Fixed Income19%

Alpha14%

Carry22%

Macro Trend0%

Equity79%

Fixed Income0%

Alpha7%

Carry14%

Macro Trend0%

Equity12%

Fixed Income3%

Alpha44%

Carry2%

Macro Trend39%


editoR / AuthoRBoaz vega, Vice President, Global Access Quantitative Analysis

Boaz Vega is a Vice President at J.P. Morgan Private Bank in New York, responsible for quantitative analysis, capital allocation across hedge fund

strategies, and the creation of proprietary analytics to evaluate sources of returns and alpha generation from alternative investments for the Global Access Portfolios. Previously, Mr. Vega held the position of Quantitative Analyst at Brevan Howard Asset Management, a London-based global macro hedge fund manager, where he worked closely with the chief investment officer of Systematic Strategies to develop a quantitative trading fund and also created proprietary models for strategy analysis and asset allocation. He has also held positions at Scribe Reports, a quantitative hedge fund advisory firm, Moore Capital, a global macro hedge fund, and Citigroup. Mr. Vega holds a Bachelors of Arts degree in Physics, a Master of Science degree in Applied Physics, and a Master of Arts degree in Mathematics of Finance from Columbia University.

ContRiButinG editoRshongtao qiao, Vice President, Global Access Risk Management

Hongtao Qiao is a Vice President at J.P. Morgan Private Bank in New York, responsible for conducting quantitative research for the Global Access Portfolios.

Prior to his current position, Mr. Qiao worked as an advisor to pensions and endowments on strategic asset allocation, liability-driven investment and risk budgeting. Before joining J.P. Morgan, he worked as a Bank Examiner for the People’s Bank of China (Central Bank of China) from 2000 to 2003. Recently, Mr. Qiao built a new asset allocation model for the firm that incorporates a measure of downside risk and assumes a non-normal distribution of returns. Mr. Qiao holds a Master of Arts in Economics from The University of Memphis, and a Master of Science in Financial Mathematics from The University of Chicago.

Rashmi Gupta, Associate, J.P. Morgan Global Access

Rashmi Gupta is an Associate and supports the Chief Investment Officer for J.P. Morgan Global Access at J.P. Morgan Private Bank in New York, with a focus

on investment strategy. Prior to her current role, Ms. Gupta worked in the Investment Banking division of Citigroup Global Markets where she focused on and executed Mergers and Acquisitions advisory, equity and debt transactions for U.S. and European commercial real estate companies. Previously, she served as Portfolio Manager for $1.5 billion in discretionary taxable fixed income assets for J.P. Morgan Private Bank. Ms. Gupta holds a Master of Business Administration from The Wharton School with a concentration in Finance, and a Bachelor of Arts in Economics, Philosophy and Political Science from the University of Pennsylvania.

ContRiButinG AuthoRGeorgiy Zhikharev, Vice President, Risk Manager, Global Access

Georgiy Zhikharev is a Vice President on the Global Strategy Team at J.P. Morgan Private Bank in New York and serves as Risk Manager for the firm’s

Global Access Portfolios. Prior to joining J.P. Morgan, he was Director and Partner at Dialogue Investments, an investment management and consulting company in Russia, responsible for proprietary portfolio investments and investment management advisory business. Mr. Zhikharev has been with J.P. Morgan for nine years and, prior to his current role, he built out the non-discretionary risk management unit of the Private Bank. He holds a Master of Business Administration with a concentration in finance from the DePaul University in Chicago, and also holds a Ph.D.-equivalent degree in Economics from the Kazan State University, Russia. Additionally, Mr. Zhikharev holds a Financial Risk Manager (FRM) designation from the Global Association of Risk Professionals.

j.P. MoRGAn GloBAl ACCessChief investMent offiCeR

Richard Madigan, Chief Investment Officer, J.P. Morgan Global Access

Richard Madigan is Managing Director, Chief Investment Officer and Head of the Investment Team managing the Global Access Portfolios at J.P. Morgan.

He is also a senior member of the J.P. Morgan Private Bank Global Strategy Team responsible for the development of investment strategy, including tactical and strategic asset allocation. In addition, Mr. Madigan is Chairman of the Hedge Fund Advisory Council, a senior member of the firm’s International Portfolio Construction Committee, and a Board member of J.P. Morgan Private Investments, Inc. Prior to his current role with J.P. Morgan, Mr. Madigan served as Managing Director, Head of Emerging Markets Investments and Senior Portfolio Manager at Offitbank, a New-York-based wealth management boutique, where he managed the firm’s emerging markets assets and investment team, including the firm’s flagship emerging markets mutual fund. Before joining Offitbank, Mr. Madigan worked for J.P. Morgan’s Investment Banking division in New York in the emerging markets securities business. He previously spent six years with Citicorp first as a banker in Mexico, and then in the firm’s international corporate finance division in New York. Mr. Madigan’s commentaries have appeared in the Financial Times, The New York Times, The Wall Street Journal, Bloomberg and Reuters. He has been a guest speaker on CNN, CNBC, and Bloomberg News, as well as various industry conferences. Mr. Madigan holds a Master’s degree from New York University, where he majored in Finance and International Business.


key Risks of investinG in AlteRnAtives

investment risk: All investments risk the loss of capital. No guarantee or representation is made that a fund’s investment program will be successful. A fund’s invest-ment program may involve, without limitation, risks associated with limited diversification and high concentration, high level of leverage, investments in speculative assets and the use of speculative and possibly untested in-vestment strategies and techniques, interest rates, currencies, volatility, tracking risks in hedged positions, security borrowing risks in short sales, credit deterioration or default risks, systems risks and other risks inherent in the Fund’s activities. Certain investment techniques of a fund (e.g., use of direct leverage or indirectly through leveraged investments) can, in cer-tain circumstances, magnify the impact of adverse market moves to which a fund may be subject.

General economic and market conditions:The success of a fund’s activities may be affected by general economic and market conditions, such as interest rates, availability of credit, infla-tion rates, economic uncertainty, changes in laws (including laws relating to taxation of a fund’s investments), trade barriers, currency exchange controls, and national and international political circumstances (including wars, terrorist acts or security operations). These factors may affect the level and volatility of securities prices and the liquidity of a fund’s invest-ments. Volatility or illiquidity could impair a fund’s profitability or result in losses. A fund may maintain substantial trading positions that can be adversely affected by the level of volatility in the financial markets.

Currency risks and non-united states investments. Investments may be denominated in non-U.S. currencies. Accordingly, changes in currency exchange rates, costs of conversion and exchange control regulations may adversely affect the dollar value of investments.

dependence on trading manager. Performance is more dependent on manager-specific skills, rather than broad exposure to a particular market.

event risk. Given their niche specialization, market dislocations can affect some strategies more adversely than others.

financial services industry risk factors. Financial services institutions have asset and liability structures that are essentially monetary in nature and are directly affected by many factors, including domestic and international eco-nomic and political conditions, broad trends in business and finance, legis-lation and regulation affecting the national and international business and financial communities, monetary and fiscal policies, interest rates, inflation, currency values, market conditions, the availability and cost of short-term or long-term funding and capital, the credit capacity or perceived creditworthi-ness of customers and counterparties, and the volatility of trading markets. Financial services institutions operate in a highly regulated environment and are subject to extensive legal and regulatory restrictions and limitations and to supervision, examination and enforcement by regulatory authorities. Fail-ure to comply with any of these laws, rules or regulations, some of which are subject to interpretation and may be subject to change, could result in a variety of adverse consequences, including civil penalties, fines, suspension or expulsion, and termination of deposit insurance, which may have material adverse effects.

General/loss of capital. An investment in alternative investment funds involves a high degree of risk. There can be no assurance that the alterna-tive investment fund’s return objectives will be realized and investors in the alternative investment fund could lose up to the full amount of their invested capital. The alternative investment fund’s fees and expenses may offset the alternative investment fund’s trading profits.

lack of information. The industry is largely unregistered and loosely regulated with little or no public market coverage. Investors are reliant on the manager for the availability, quality and quantity of information. Information regarding investment strategies and performance may not be readily available to investors.

leverage. The capital structures of many financial services companies typically include substantial leverage. In addition, investments may be consummated through the use of significant leverage. Leveraged capital structures and the use of leverage in financing investments increase the exposure of a company to adverse economic factors such as rising interest rates, downturns in the economy or deteriorations in the condition of the company or its industry and make the company more sensitive to declines in revenues and to increases in expenses.

limited liquidity. Interests are not publicly listed or traded on an exchange or automated quotation system. There is not a secondary market for inter-ests, and as a result, invested capital is less accessible than that of tradition-al asset classes. Also, withdrawals and transfers are generally restricted.

Potential conflicts of interest. The payment of a performance-based fee to the Trading Manager may create an incentive for the Trading Manager to cause the alternative investment fund to make riskier or more speculative investments than it would in the absence of such incentive.

speculation. Alternative investments often employ leverage, sometimes at significant levels, to enhance potential returns. Investment techniques may include the use of derivative instruments such as futures, options and short sales, which amplify the possibilities for both profits and losses and may add volatility to the alternative investment fund’s performance.

valuation. Because of overall size or concentration in particular markets or positions held by the alternative investment fund or other reasons, the value at which its investments can be liquidated may differ, sometimes significantly, from the interim valuations arrived at by the alternative in-vestment fund.

definitions of indiCes

hfRi equity hedge index. Equity hedge investing consists of a core hold-ing of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 Index and put spreads. Conservative funds mitigate market risk by maintaining market exposure from zero to 100 percent. Aggressive funds may magnify market risk by exceeding 100 percent exposure and, in some instances, maintain a short exposure. In addition to equities, some funds may have limited as-sets invested in other types of securities.

hfRi event driven index. Investment managers that maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, finan-cial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure in-cludes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company-specific developments. Investment theses are typi-cally predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exog-enous to the existing capital structure.

hfRi fund weighted Composite index. Includes both domestic and off-shore funds. The index is equal-weighted and does not include fund of funds. All funds report assets in $USD. All funds report net of all fees. Returns of all funds are reported on a monthly basis. All funds have at least $50 million under management or have been actively trading for at least 12 months.


hfRi Macro index. Investment managers that trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers em-ploy a variety of techniques, both discretionary and systematic analysis, combinations of top-down and bottom-up theses, quantitative and funda-mental approaches and long- and short-term holding periods. Although some strategies employ relative value techniques, macro strategies are distinct from relative value strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instru-ments, rather than realization of a valuation discrepancy between securi-ties. In a similar way, while both macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposed to equity hedge, in which the fundamental characteristics on the company are the most significant and are integral to the investment thesis.

hfRi Relative value index. Investment managers that maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to estab-lish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk-adjusted spread between these instruments represents an attractive opportunity for the investment manager. Relative value position may be involved in corporate transactions also, but as opposed to event driven exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.

the MsCi world index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. The MSCI World Index consists of the following 23 developed market coun-try indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zea-land, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States.

the s&P 500 index (“S&P 500”) consists of 500 stocks chosen for mar-ket size, liquidity and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value. All re-turns include reinvested dividends except where indicated otherwise. The S&P 500 Total Return Index also includes dividends reinvested.

definitions of hedGe fund stRAteGies

diversified. Multi-strategy approach that is diversified among the primary strategies listed below. Manager is able to blend individual strategies to create higher efficiency and lower volatility.

long/short equity. Long or short positions in equities or options deemed to be under- or overvalued. Manager does not attempt to neutralize the amount of long and short positions (i.e., will be net long or net short).

event driven. Special situations: investments in companies whose capital structure is undergoing change.

Merger arbitrage. Investments in securities of firms involved in mergers.

distressed. Investments in companies in reorganization or bankruptcy.

Macro-opportunistic

Global macro. Analyze fundamental and economic data to seek to capitalize on the relative economic strengths/ weaknesses of countries, regions or currencies.

opportunistic. Generally, funds that are usually aggressive and seek to make money in the most efficient way at a given time.

Relative value. Involves simultaneous purchase and sale of similar securi-ties to exploit pricing differentials. Also attempts to neutralize long and short positions to minimize the impact of general market movements. This closely describes the equity market neutral, sub-strategy, but also applies to fixed income arbitrage (e.g., reduce exposure to the yield curve) and statistical arbitrage (e.g., quantitative analysis of technical factors) sub-strategies.


iMPoRtAnt infoRMAtion

iRs Circular 230 disclosure: jPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of u.s. tax matters contained herein is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with jPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding u.s. tax-related penalties.

Each recipient of this presentation, and each agent thereof, may disclose to any person, without limitation, the U.S. income and franchise tax treatment and tax structure of the transactions described herein and may disclose all materials of any kind (including opinions or other tax analyses) provided to each recipient insofar as the materials relate to a U.S. income or franchise tax strategy provided to such recipient by JPMorgan Chase & Co. and its subsidiaries.

This document has been prepared for investors who are eligible and are suitable to invest in the type of investment described herein. Generally, they would include investors who are “accredited investors” under the Securities Act of 1933 and “qualified purchasers” under the Investment Company Act of 1940. This material is intended to inform you of products and services offered by J.P. Morgan’s Private Bank. The private banking business of J.P. Morgan is conducted by JPMorgan Chase & Co. and its subsidiaries worldwide. JPMorgan Chase Bank N.A. (“JPMCB”) is a member of the FDIC. J.P. Morgan Securities LLC (“JPMS LLC”) is a broker-dealer and member of the NYSE, FINRA (and other national and regional exchanges) and SIPC. Securities prod-ucts and services are offers through JPMS LLC and its brokerage affiliates. The broker-dealers are not banks and are separate legal entities from their bank affiliates. Bank products and services are provided through JPMCB, and its. JPMorgan Chase & Co. may operate various other broker-dealers or investment advisory entities. In the U.S., private bankers are registered representatives of JPMS LLC.

In the United Kingdom, this material is approved for issue by J.P. Morgan International Bank Limited (JPMIB) authorised and regulated by the Financial Services Authority. In addition, this material may be distributed by: JPMCB Paris branch, which is regulated by the French banking authorities Autorité de Contrôle Prudentiel and Autorité des Marchés Financiers; J.P. Morgan (Suisse) SA, regulated by the Swiss Financial Market Supervisory Authority; JPMCB Bahrain branch, regulated by the Central Bank of Bahrain; JPMCB Dubai International Financial Centre branch, regulated by the Dubai Financial Services Authority; JPMCB Hong Kong branch, regulated by the Hong Kong Monetary Authority; JPMCB Singapore branch, regulated by the Monetary Authority of Singapore.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice. This material should not be regarded as research or a J.P. Morgan research report. Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan, including research. The investment strategies and views stated here may differ from those expressed for other purposes or in other contexts by other J.P. Morgan market strategists. JPMS LLC may act as a market maker in markets relevant to structured products or option products and may engage in hedging or other operations in such markets relevant to its structured products or options exposures. Structured prod-ucts and options are not insured by the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board, or any other governmental agency. In discussion of options and other strategies, results and risks are based solely on hypothetical examples cited; actual results and risks will vary depending on specific circumstances. Investors are urged to consider carefully whether option or option-related products in general, as well as the products or strategies discussed herein, are suitable to their needs. In actual transactions, the client’s counterparty for OTC derivatives applications is JPMIB. For a copy of the “Characteristics and Risks of Standardized Options” booklet, please contact your J.P. Morgan Advisor.

Real estate, hedge funds, and other private investments may not be suitable for all investors, may present significant risks, and may be sold or redeemed at more or less than the original amount invested. Private investments are offered only by offering memoranda, which more fully describe the possible risks. There are no assurances that the stated investment objectives of any investment product will be met. Hedge funds (or funds of hedge funds): often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any hedge fund.

Past performance is no guarantee of future results.Additional information is available upon request.

© 2010 JPMorgan Chase & Co.

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