Download - JPMorgan Alternative Asset Management
JPMorgan Alternative Asset Management
Hedge Fund Educational Overview
Q2 2008
1
Agenda
� What is a Hedge Fund?
� Why Invest in Hedge Funds?
� Industry Environment
� Case Study
� Appendix
2
Before we begin, always remember!
� No risk means no reward, but high risk doesn’t mean high reward.
� One can learn from past history, but historical performance and events do not guarantee future ones.
� When it’s too good to be true, it usually is…
� There is no free lunch!
3
So what is a hedge fund exactly?
� Hedge funds are actively managed. (alpha vs. beta)
� Hedge funds have flexible investment guidelines. (leverage, short sales, derivatives)
� Hedge funds’ liquidities are limited. (monthly subscription and quarterly redemption)
� Hedge funds charge performance fees in addition to management fees. (absolute return target)
� Hedge fund managers are investors/partners as oppose to employees. (alignment of interests)
� Hedge funds have limited transparency. (double edge sword)
The term “hedge fund” is not defined or used in the federal securities laws, but most hedge funds do share some common characteristics:
4
Agenda
� What is a Hedge Fund?
� Why Invest in Hedge Funds?
� Industry Environment
� Case Study
� Appendix
5
Why invest in hedge funds?
� Differentiated source of return
� Consistent, attractive risk-adjusted returns
� Low correlation with traditional asset classes
� Absolute return concept
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Sources of return
Manager skill(Alpha)
Market exposure(Beta)
Equities
Fixed income
Traditional assetclasses
Arbitrage
HighHigh LowLow
HighHigh LowLow
Moderate HighHigh
HighHigh
Source: JPMAAM References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.
Directional
Hedge funds offer a differentiated source of return
Volatility
Hedge funds
LowLow
Moderate
LowLow
HighHigh
LowLow
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Hedge funds offer consistent and attractive risk ad justed returns
July 1998 – June 2008
As of June 30, 2008. Source: Hedge Fund Research. Past performance may not be indicative of future results.
Relative Value Arbitrage
Distressed Securities Equity Hedge
Event-Driven
Macro
Merger Arbitrage
Short Selling S&P 500
0%
2%
4%
6%
8%
10%
12%
14%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
Volatility (Standard Deviation)
Ann
ualiz
ed R
etur
n
8
Hedge funds offer consistent and attractive risk ad justed returns (cont’d)
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF F UTURE RESULTS. See “Definition of Terms and Indices” and “Risk Disc losures”.
Data from January 1993 to December 2007.(1) Represented by the S&P 500 Total Return Index. (2) Represented by the Lehman Brothers Aggregate Bond Index.(3) Represented by the MSCI World Total Return Index.(4) Represented by an investment in Highbridge Capital Corporation, available only to accredited and/or qualified investors via private placement.
3-Year (Annualized) 5-Year (Annualized) 10-Year (Annu alized)
ROR Volatility Beta ROR Volatility Beta ROR Volatility Beta
Domestic Equities (1) 8.62% 7.79% 1.00 12.83% 8.61% 1.00 5.91% 14.72% 1.00
Domestic Bonds (2) 4.56% 2.81% -0.06 4.42% 3.59% -0.03 5.97% 3.47% -0.05
International Equities (3) 12.33% 8.78% 1.00 16.14% 9.53% 1.03 5.87% 14.33% 0.93
Hedge Fund Portfolio (4) 11.16% 6.04% 0.41 10.29% 5.09% 0.20 13.47% 5.14% 0.12
Over the long term, a diversified hedge fund portfolio may offer equity-like returns and bond-like risk characteristics
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Hedge funds have low correlation with traditional as set classes
1 Measure of risk adjusted return. The risk-free rate is the U.S. 3-Month T-Bill rate annualized over the period. 2 Maximum drawdown is the largest percentage drawdown during the period3 Hedge Fund Research (HFR) is a widely used industry benchmark, although the exact composition of this index remains proprietary. Data as of June 30, 2008. Past performance is no guarantee nor necessarily indicative of future results.
July 1998 - June 2008
S&P 500MSCI World -
Local
J.P. Morgan Global Bond -
Hedged
Lehman Aggregate Bond
Hedge Fund Research (HFR) Fund Weighted
Index 3
Return 2.88% 2.70% 5.31% 5.68% 9.34%
Standard Deviation 14.96% 14.25% 3.02% 3.50% 7.20%
Sharpe Ratio 1 -0.03 -0.05 0.64 0.66 0.83
Correlation with HFR Fund Weighted Index 0.72 0.78 -0.26 -0.14 -
Maximum Drawdown 2 -44.73% -45.94% -2.91% -3.55% -9.42%
S&P 500MSCI World -
Local
J.P. Morgan Global Bond -
Hedged
Lehman Aggregate Bond
Hedge Fund Research (HFR) Fund Weighted
Index 3
Return 2.88% 2.70% 5.31% 5.68% 9.34%
Standard Deviation 14.96% 14.25% 3.02% 3.50% 7.20%
Sharpe Ratio 1 -0.03 -0.05 0.64 0.66 0.83
Correlation with HFR Fund Weighted Index 0.72 0.78 -0.26 -0.14 -
Maximum Drawdown 2 -44.73% -45.94% -2.91% -3.55% -9.42%
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Absolute Return Concept
Funds have high potential to generate positive returns even when the overall market is down.
Eurekahedge index is a widely used hedge fund industry benchmark although the exact constituent data remains proprietary. Data is as of November 2008.Past performance is no guarantee nor necessary indicative of future results.
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Absolute Return Concept (cont’d)
Average monthly over the period July 1998 - June 200 8
* HFR Composite reflects performance of HFRX Global Hedge Fund Index (April 2003 – June 2008), HFRI Fund Weighted Composite Index (January 1998 –March 2003). Indices are unmanaged, do not charge fees and are shown for illustrative purposes only.Contains performance as of June 30, 2008. Past performance is no guarantee nor necessarily indicative of future results.
3.17%
1.53%
-0.86%
-3.65%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
S&P up months S&P down months
S&P 500 HFR Composite*
3.17%
1.53%
-0.86%
-3.65%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
S&P up months S&P down months
S&P 500 HFR Composite*
Hedge funds protects capital in down markets.
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Benefits of allocating to hedge funds in a diversif ied portfolio
Hedge funds added to a portfolio of U.S. stocks and bonds enhance the risk/return profile
*Hedge Fund Composite represented by HFRI Fund Weighted Composite Index (net of manager fees).Financial information as of December 31, 2007. Past performance may not be indicative of future results. Indices are shown for illustrative purposes. Indices are not available for investment by the public nor are fees and expenses charged by indices. This is not intended and should not be interpreted as the performance of an actual investment.
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16%
Annualized Standard Deviation (Volatility)
Risk and Return of Stocks, Bonds and Hedge Funds: J anuary 1993 – December 2007
50% S&P 500 and 50% Lehman Govt./Corp. Bond
100% LehmanGovt./Corp. Bond
100% Hedge FundComposite*
100% S&P 500
Ann
ualiz
ed R
etur
n
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What are the key risks of hedge fund investing?
Limited/Poor Information
Liquidity Risk
Manager Risk
Headline Risk
Event Risk
� Investors are reliant on the manager for the availability, quality and quantity of information.
Leverage Risk
� Invested capital is generally less accessible than that of traditional asset classes. For example, most hedge funds have quarterly or annual liquidity.
� The performance of hedge funds is more dependent on manager-specific skills, rather than broad exposure to a particular market.
� Negative media publications pertaining to hedge funds.
� Hedge funds often use leverage, sometimes at significant levels, to enhance potential returns.
� Given their niche specialization, market dislocations can affect some hedge fund strategies more adversely than others.
Operational Risk�The business that supports the investment activities of the manager ―
infrastructure, operational controls/systems, accounting, legal structure, documentation, etc. ― are equally as important as investment attributes.
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Manager Risk: Dispersion of Hedge Fund Returns vs. Traditional Long Only
Note: Long-only data source is Mobius M-search; hedge fund strategy data source is Hedge Fund Research (HFR).
� Each bar chart depicts the quartile distribution of hedge fund manager returns (normalized around the median – i.e., 0% return) for each hedge fund strategy as well as a universe of large capitalization, long-only equity managers
� Hedge fund manager selection seems most important in Long/Short equities and other directional strategies
Note: Methodology: Performance of funds in each strategy is ranked from best to worst with top 5% and bottom 5% excluded. Each fund’s performance is compared with the strategy’s median (0%) to arrive at distribution as depicted on charts.
Data represent trailing 10-year period (January 1998 – December 2007)
-20%
-10%
0%
10%
20%
Long/ShortEquities
Opportunistic/Macro
Short Selling DistressedSecurities
Relative Value Merger Arbitrage Long Only
Per
form
ance
Rel
ativ
e
to 5
0th
perc
entil
e
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One way to mitigate manager risk is through a multi-manager approach…
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
0% 10% 20% 30% 40% 50% 60%
Single Fund 25 Fund Portfolio
Source: Returns and dispersion data represent returns from January 1998 to December 2007 of hedge funds in the Hedge Fund Research (HFR) database. Fund selection based on availability of continuous historical monthly returns from January 1998 to December 2007. Based on this screen, there were 1284 funds in the universe. Funds in the HFR database which were not in continuous existence from January 1998 to December 2007 are not included in the analysis. The 25-fund Portfolio represents a stratified sample of hedge funds, where managers are first separated into 6 distinct categories: long/short equities, short selling, distressed securities, relative value, merger arbitrage/event, and opportunistic/macro. Then we randomly selected managers in those strategies. This information is shown for illustrative purposes only. It is not intended and it should not be interpreted as the performance of an actual investment.
(Randomly Selected)
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
0% 10% 20% 30% 40% 50% 60%
Annualized VolatilityAnnualized Volatility
Ret
urn
Ret
urn
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…and similarly, a multi-strategy approach can impro ve risk-adjusted returns
Source: Hedge Fund Research (HFR) Database (Estimated data & January 1998 – December 2007). 1 The Relative Value Index is the HFR Convertible Arbitrage Index.2 The HFR Equally Weighted Portfolio is a combination of the HFR Equity Hedge Index, Convertible Arbitrage Index, HFR Macro Index, HFR Merger Arbitrage Index, HFR Distressed Securities Index and the HFR Short Selling Index rebalanced quarterly.3 Measure of risk adjusted return on investment. Calculated using the U.S. 3-month T-Bill rate annualized over the period. This information is shown for illustrative purposes only. It is not intended and it should not be interpreted as the performance of an actual investment.
January 1998 - December 2007
Long/Short Equities
Relative Value 1
Opportunistic/Macro
Merger Arbitrage
Distressed Securities
Short SellingEQUALLY
WEIGHTED PORTFOLIO2
Return 11.96% 8.38% 9.12% 10.70% 10.80% 1.59% 9.38%
Standard Deviation 9.14% 3.62% 6.06% 6.47% 5.68% 20.84% 3.00%
Maximum Drawdown -10.30% -7.36% -7.32% -10.78% -12.78% -51.05% -4.57%
Sharpe Ratio3 0.92 1.34 0.92 1.11 1.28 -0.09 1.94
Correlation with S&P 0.71 0.25 0.29 0.67 0.45 -0.72 0.04
Avg. Return when S&P Declines
-0.40% 0.19% 0.03% -0.19% 0.06% 1.91% 0.27%
Long/Short Equities
Relative Value 1
Opportunistic/Macro
Merger Arbitrage
Distressed Securities
Short SellingEQUALLY
WEIGHTED PORTFOLIO2
Return 11.96% 8.38% 9.12% 10.70% 10.80% 1.59% 9.38%
Standard Deviation 9.14% 3.62% 6.06% 6.47% 5.68% 20.84% 3.00%
Maximum Drawdown -10.30% -7.36% -7.32% -10.78% -12.78% -51.05% -4.57%
Sharpe Ratio3 0.92 1.34 0.92 1.11 1.28 -0.09 1.94
Correlation with S&P 0.71 0.25 0.29 0.67 0.45 -0.72 0.04
Avg. Return when S&P Declines
-0.40% 0.19% 0.03% -0.19% 0.06% 1.91% 0.27%
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Agenda
� What is a Hedge Fund?
� Why Invest in Hedge Funds?
� Industry Environment
� Case Study
� Appendix
18
Growth of hedge fund industry continues
0
2,000
4,000
6,000
8,000
10,000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD2008
$0
$500
$1,000
$1,500
$2,000
$2,500
Number of Hedge Funds
Assets ($ billions)
Num
ber
of H
edge
of F
unds A
ssets ($ billions)
As of June 30, 2008.Source: Hedge Fund Research Industry Report – Second Quarter 2008.
• Assets within the hedge fund industry have grown at an unprecedented rate throughout the last decade
• New hedge funds have grown at an unprecedented rate throughout the last decade
Estimated growth of hedge fund assets and number of hedge funds (1990 to YTD 2008)
$1,931BN10,294 funds
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Percentage of plans anticipating an increase/decrea se in strategic allocations
5%
25%
11%
27%
17%
2%9%
28% 31%
22%
-32%
-8%-1% -3%
-15%
-28%
-2%0% 0%0%
Equities Fixed income Real estate Private equity Hedge funds
“Do you anticipate an increase, decrease or no change to your asset allocation to…?”Base: Corporate (75), Public (54)
Corporate plans Public funds% anticipating an increase in
allocations
% anticipating a decrease
in allocations
Source: JPMorgan Asset Management Survey — Pension Investment Strategies for a New Playing Field, December 2006
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Globalization of Hedge Funds
� Globalization fueled by …
– developments on the regulatory and hedging fronts– investors’ quest for new sources of alpha
Source: EuroHedge and AsiaHedge, 1999-2006. Total hedge fund AUM from HFR Year End 2006 Industry Report.
38.6%34.6%29.9%22%15.3%11.9%9.6%5.5%Percentage of total HF AUM
$91$69$35$21$12$7$6N/ATotal Asia
$460$313$256$160$84$57$41$25Total Europe
985866412283N/AOther Europe
362255190119624938N/AUnited Kingdom
20062005200420032002200120001999
Dollars managed by non-U.S. based managers ($ in bi llions)
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Hedge Fund Strategy Evolution
As of June 30, 2008. Source: Hedge Fund Research Industry Report – Second Quarter 2008
Estimated Strategy Composition by AUM
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1990 1995 2000 2005 YTD 2008
Equity Hedge Event-Driven Macro Relative Value
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Estimated Fund Domicile Registration
Data source : HFR
23
Estimated Fund Minimum Investment Size
Data source : HFR
24
Estimated Fund Age Q2 2008
Data source : HFR
25
Estimated Investment Subscription / Redemptions Q2 2008
26
HFRI Fund Weighted Composite Index Performance by Cu rrent Management Fee Basket
27
Current environment presents challenges…
� Increased equity beta and strategy correlation
– Equity managers increase beta during market strength
– Macro and relative value strategies expanding into equities and/or tilting neutrality stance
� Institutionalization
– Hedge fund conservatism
– Single managers focused on building a hedge fund “business” and becoming increasingly institutionalized
� Alpha erosion
– Arbitrage strategies
– Probable decrease in alpha duration
� Headline risk
– Few, but high-profile, frauds
� Access
� Increased complexity of terms
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Pairwise correlations and beta among hedge funds had been increasing
Hedge Fund Indices 1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
Mar
-97
Sep
-97
Mar
-98
Sep
-98
Mar
-99
Sep
-99
Mar
-00
Sep
-00
Mar
-01
Sep
-01
Mar
-02
Sep
-02
Mar
-03
Sep
-03
Mar
-04
Sep
-04
Mar
-05
Sep
-05
Mar
-06
Sep
-06
Mar
-07
Sep
-07
Mar
-08
Hedge Fund Indices' Correlations HFR Composite Beta to S&P 500
Pairwise correlations
Beta to S&P 500
2
Note: Information estimated as of March 31, 2008.1 Hedge Fund Indices shown are from the following sources: Credit Suisse First Boston/Tremont, Hedge Fund Research (HFR) Database (April 1995 onwards). Return series include: HFR Equity Hedge Index, HFR Relative Value Arbitrage Index, HFR Macro Index, HFR Event Driven Index, HFR Distressed Securities Index and the CSFB/Tremont Dedicated Short Bias Index.2 HFR Composite reflects performance of HFRX Global Hedge Fund Index (April 2003 onwards), HFRI Fund Weighted Composite Index (April 1995–March 2003). Pairwise correlations represent the asset-weighted intra-strategy correlations across the six investible hedge fund indices indicated herein.
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…but, opportunities for success are still abundant
� Plenty of investment opportunities remain
– geographic expansion
– emergence of new strategies
� Research depth and breadth will distinguish the bes t
– access and negotiated capacity is crucial
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Agenda
� What is a Hedge Fund?
� Why Invest in Hedge Funds?
� Industry Environment
� Case Study
� Appendix
31
HCM and JPMorgan Asset Management: Highbridge Strategies Offered via JPMorgan
LONG-ONLYLONG-ONLYMARKET-NEUTRALAPPROACH
VERY HIGHVERY HIGHVERY HIGHPOSITION / PORTFOLIO
DIVERSIFICATION
Near 1 (to S&P 500)Near 1 (to MSCI Europe) Near 0 (to S&P 500)BETA
UCITS III SICAVUCITS III SICAVUCITS III SICAVINVESTMENT VEHICLE
STRATEGY / FUND INCEPTION
LIQUIDITY
TARGET VOLATILITY
OBJECTIVE (1)
STRATEGY
Strategy Inception: January 2005(3)
Fund Launch: May 27, 2008Strategy Inception: January 2006(2)
Fund Launch: February 7, 2008Strategy Inception: June 2002
Fund Launch: November 6, 2006
DailyDailyDaily
Similar to that of the S&P 500 Total Return Index
Similar to that of the MSCI Europe Total Return Index
4-6% per year
To provide long term capital growth by investing primarily in U.S. companies
To provide long term capital growth by investing primarily in European companies
To provide a total return in all market environments in excess of the return on
short-term instruments, through a market neutral strategy
Quantitative, long-only approach to investing in US equities
Quantitative, long-only approach to investing in European equities
Quantitative, market neutral approach to investing in US equities
JPM Highbridge US STEEP
JPM Highbridge Europe STEEP
JPM Highbridge Statistical Market Neutral Fund
(1) Over a full market cycle.(2) Highbridge has been managing the Europe STEEP strategy for investment vehicles at Highbridge since January 2006. (3) Highbridge has been managing the US STEEP strategy for investment vehicles at Highbridge since January 2005.
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* (1) The target return represents the investment manager’s estimate of the potential return for the Fund and does not form and nor is it a part of the Fund’s investment objective or policy. There is no guarantee that this target return will be achieved.(2) European Overnight Index Average.(3) British Banker’s Association (BBA) LIBOR USD Overnight Index (Total Return Gross) (4) Based on weekly observations since inception to 30/06/08.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF F UTURE RESULTS.
Performance SummaryNovember 2006 (inception) to July 31, 2008�Fund Launch: 06/11/2006 and opened for client
dealing 13/11/2006
�Investment Universe: ~1,500 most liquid equities in the U.S. market
�Target Return (1): 400-500 bps over cash benchmark (EONIA(2) or LIBOR(3)) after fees(4)
�Target Volatility: 4-6% per year
�Dealing Frequency: Daily
�Performance Fees:
– 20%
– Hurdle Rate EONIA
�Base Currency: Euro with USD Hedged share classes available
�Correlation to S&P 500 (4): -0.045
�Beta to S&P 500 (4): -0.017
Investment Terms
JPM Highbridge Statistical Market Neutral Fund: Terms and Performance Summary
* A share class was launched on November 6, 2006.** EONIA cumulative returns are for the period matching the inception date of the A share class.
JPM HSMN A (acc) – EUR* EONIA**
2006 Nov 0.63% 0.22%Dec 0.63% 0.28%
2007 Jan 1.09% 0.33%Feb 0.32% 0.28%Mar 0.97% 0.30%Apr 0.61% 0.33%
May 0.30% 0.33%Jun (0.26%) 0.32%Jul (1.10%) 0.36%
Aug (1.40%) 0.35%Sep (0.67%) 0.31%Oct (0.22%) 0.36%
Nov 0.26% 0.34%Dec (0.31%) 0.33%
2008 Jan 1.32% 0.34%Feb 2.10% 0.33%Mar 0.56% 0.35%Apr 0.58% 0.33%
May 2.09% 0.33%June 1.59% 0.34%July (0.24%) 0.36%
2008 YTD 8.25% 2.42%Cumulative Return 9.14% 7.07%
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� Offers a differentiated asset class for portfolio diversification
– Hedge the common or systematic risks that cause volatility in long-only positions
– Stock selection process drives portfolio returns
� Offers an "Absolute Return" focus
– Buy stocks that appear attractive while sell-short the stocks that appear unattractive
– Add value if the attractive stocks outperform the unattractive stocks
� Seeks to offer low correlation with other investments
– Focus is on manager and model capabilities, a fundamentally different source of return than traditional "long" equity or bond portfolios
Diversification does not guarantee investment returns and does not eliminate the risk of loss.The manager seeks to achieve the stated objectives. There can be no guarantee the objectives will be met.
The benefits of market neutral strategies
34
Diversification Benefits of JPM HSMNF
Worst Months of Performance for S&P (1) Average Daily Returns for Days when S&P 500 Index was Down (1)
The Fund’s performance on the worst days of performance for the S&P demonstrates its value as an effective portfolio diversifier
(1) Source: Bloomberg. S&P 500 index returns assume dividends reinvested. Data from 11/30/06 to 07/31/08.
(0.85%)
0.03%
(1.00%)
(0.50%)
0.00%
0.50%
S&P 500 JPM HSMNF
(3.10%)(4.18%)
(6.64%)
(3.25%)
(8.43%)
(1.10%)
0.26%1.32%
2.10%1.59%
(10%)
(5%)
0%
5%
Jul-07 Nov-07 Jan-08 Feb-08 Jun-08
S&P 500 JPM HSMNF
35
What is Statistical Arbitrage?
� Aims to identify and profit from mispricings in security prices using a quantitative , systematic approach to investing
� Seeks to predict stock price movements and estimate their returns using mathematical models to analyse historical and real-time data
� Utilises a fully automated investment process, where sophisticated computer algorithms govern decisions rather than a team of people
� Seeks portfolio returns driven by stock-specific risk (alpha ) rather than exposure to market risk (beta )
� Attempts to forecast security returns drawing on relationships that research seems to show are consistent, effective predictors of returns in diverse market environments
(1) These strategies do not describe any fund or manager.Note: This information reflects JPMAM’s opinion and goals and should not be understood as a prediction or projection of actual investments that will be made or transactions that will be achieved. There can be no assurance that suitable investments will be identified or that these strategies will be effected. This investment strategy involves significant risks, including availability of opportunities and execution of ideas, and is subject to change without notice. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice, as are statements of traditional fixed income strategies. Please see "Risk Disclosures" for important information.
It is a trading strategy that:
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Differences from Traditional Equity Managers
� Purely quantitative– Fully automated and driven by sophisticated computer algorithms
– Analyzes large quantities of data faster and more accurately than teams of people
– Researchers developed models that follow instructions on how to execute investment process
� Different level of manager involvement– On day-to-day basis, portfolio managers actively monitor, test and extend the quantitative model
– Team continuously researches new investment insights to incorporate into the model
– Portfolio construction is not constrained by manager’s time
– Teams of research analysts may intervene in times of crisis
� Large numbers of small bets– Portfolio consists of a large number of holdings, broadly diversified across sectors
– Each trade targets relatively small profit decrease total risk relative to total expected return
– High portfolio turnover is generally necessary but successful execution requires low transaction costs
Note: This information reflects JPMAM’s opinion and goals and should not be understood as a prediction or projection of actual investments that will be made or transactions that will be achieved. There can be no assurance that suitable investments will be identified or that these strategies will be effected. This investment strategy involves significant risks, including availability of opportunities and execution of ideas, and is subject to change without notice. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice, as are statements of traditional fixed income strategies. Please see "Risk Disclosures" for important information.
37
Statistical Arbitrage Investment Process
A Statistical Arbitrage portfolio results from the interaction of the system’s four components
OrderManagement
SystemOptimiser
Factor Model
Forecasting System
Portfolio
(Stock Selection)
(Risk Management)
(Portfolio Construction & Rebalancing)
(Trade Execution)
38
Forecasting System
OrderManagement
SystemOptimiser
Factor Model
Forecasting System
Long-term (1 to 3 months)
Long-term (3 weeks to 3 months)
Medium-term (1 day to 3 weeks)
Short-term (Less than 1 day to 1 week)
Investment Horizon
– Buy stocks with lower price-to-earnings ratios relative to peers
– Sell/Close out stock of companies with much higher price-to-earnings ratios relative to peers
Stocks with a high price-to-earnings ratio may be unjustifiably more expensive than their peers
Relative Value
– Buy stocks with positive news announcements
– Sell/Close out stocks with negative news announcements
News Parser - Stock prices tend to react to firm-specific news in a predictable way
Event
– Buy stocks whose price has been temporarily depressed due to excess supply
– Sell/Close out stocks with excess demand
Stocks prices react to short term imbalances in supply and demand
Technical / Liquidity Providing
Fundamental
Forecast Type
– Buy stock of companies with low accruals in their financial statements
– Sell/Close out stock of companies with high accruals
Firms that show high accruals in their financial statements tend to have higher likelihood of missing future earnings
ImplementationExamples of Arbitrage Opportunity
Portfolio
(1) These examples are for illustrative purposes only and do not constitute an exhaustive list. These may not necessarily reflect forecasts currently employed by the model. Forecasts are subject to modification at management’s discretion. The Fund may be managed differently.
� Highbridge’s Proprietary Forecasting System seeks to identify investment opportunities
� The Forecasting System develops a single view on each stock in the investment universe
� Expresses Highbridge’s view of predictable sources of equity returns, incorporating similar valuation techniques and methods used by traditional equity managers and using both historical and real-time data, including security prices and accounting information
39
Factor Model
Market Risk Stock-Specific Risk
Return Characteristics of a Stock
� The Factor Model serves as an integral part of the risk management function for the strategy– Seeks to identify and estimate drivers of a stock’s return, due to market and stock-specific factors
– Seeks to diversify portfolio exposure to common and statistically-derived factors in an attempt to reduce concentrated exposures of market risk
Common Factors
�Market forces that contribute to stock price movements:
– Sector/Industry– Capitalization size– Style (value/growth)– Momentum– Volatility– Yield– Dividend
Statistically-DerivedFactors
�Statistical methods attempt to identify risk exposures not captured by common factor analysis
�This Principal Components Analysis supplements common factor analysis
�Proprietary estimation of stock-specific risk
�Attempt to be highly diversified across stock-specific risks by holding large number of names
Stock-Specific Residuals
Beta Alpha
Portfolios driven primarily by stock-specific risk seek to produce higher risk-adjusted returns than broad equity markets
Elements of Risk
OrderManagement
SystemOptimiser
Factor Model
Forecasting System
Portfolio
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Optimiser
� Serves as portfolio construction component, seeking to identify and hold that combination of stocks that will potentially maximise return, minimise risk and balance portfolio risk across time
� Identifies trades to bring existing portfolio closer to “optimal” portfolio in the current market environment within constraints of Factor Model
– Assembles ranked list of stocks according to estimated risk-adjusted return, based on Forecasting System’s return predictions and Factor Model’s risk exposure penalties
� Rebalances every 5 minutes throughout the trading day, incorporating most recent information available, including changes in return estimates, risk exposures, real-time change in stock prices, volumes and transaction costs(1)
Forecasts(Expected Return)
Factors(Risk Models)
OptimiserOrder
Management System
Information onExecution costs and
Market impact(1) The optimiser generates a new order list every 5 minutes. The manager reserves the right to make changes to the scheduling process in response to software improvements.(2) These examples are for illustrative purposes only and do not constitute an exhaustive list.
OrderManagement
SystemOptimiser
Factor Model
Forecasting System
Portfolio
Trade list
NYSEAMEX
ArchipelagoIsland
InstinetBrut
ElectronicMarkets (2)
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Order Management SystemA sophisticated integrated Order Management System is essential for high turnover strategies� Efficiently executes trades by minimising market impact and other transaction costs
– Contains a micro-optimiser with refined algorithms to determine optimal size, timing and aggressiveness of trades
� Continuously evaluates market conditions and submits orders and cancellations� Serves as real time interchange between Optimiser and electronic markets
– Within each five minute interval, provides Optimiser information about which trades have been filled (in part or in full) or have not been executed due to unfavourable conditions
� Trades only via electronic communication networks– May offer rebates for providing liquidity(1)
OrderManagement
SystemOptimiser
Factor Model
Forecasting System
Portfolio
Forecasts(Expected Return)
Factors(Risk Models)
OptimiserOrder
Management System
Information onExecution costs and
Market impact
Trade list
NYSEAMEX
ArchipelagoIsland
InstinetBrut
ElectronicMarkets (2)
(1) Highbridge may receive monetary rebates for posting liquidity with certain ECNs. The amount of the rebate will vary depending on each agreement reached with the ECNs.(2) These examples are for illustrative purposes only and do not constitute an exhaustive list.
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HSMNF Performance Review
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HSMNF Performance Review (cont’d)Inception to July 2007� The Fund delivered consistent, positive returns � Volatility was generally low, with mild spikes in late
February� All four stock selection forecasting themes worked well,
with no single theme significantly dominating returns
August 2007� An unprecedented market dislocation occurred in early
August as traders affected by losses in credit portfolios rapidly reduced leverage to create cash
� This dramatic series of portfolio liquidations broadly impacted relative value, market neutral and quant equity managers and strategies
� The Fund experienced poor performance from relative value forecasts which outweighed other themes
September to December 2007� Continued portfolio liquidations and unusual trading
behavior from quant and relative value managers continued to present a challenging environment
� Longer-term and relative value forecasts remained weak
January 2008 - Present(1)
� All four stock selection themes improved, resulting in stronger and more consistent performance
� The Fund appears to be capitalizing on higher market volatility, less crowding and less capital deployed in quant strategies
Source: Bloomberg.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF F UTURE RESULTS.
Inception to July 2007 Sept – Dec 2007
2008YTD
AUGUST
(1) Through July 31, 2008.
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Is hedge fund the right investment for you?
� Understanding hedge funds is not an option, but a requirement
� Manager selection is key
� Asset allocation and diversification
� Investor can lose up to full amount of their capital even when investing in a low volatility product
� Limited liquidity
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Finally it’s over!
Thank you for your time.
46
Agenda
� What is a Hedge Fund?
� Why Invest in Hedge Funds?
� Industry Environment
� Case Study
� Appendix
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Appendix: Glossary
ALPHA: The excess return of a fund relative to the return of the benchmark index.
BETA: Measures the risk or volatility of the hedge fund manager relative to the specified benchmark. It represents the change in return for every 1% change in the index. If the beta is more than 1, the investment typically gains or loses more than the index. Beta measures the slope of the curve that depicts the investment's performance.
CAPITAL STRUCTURE ARBITRAGE: Investment strategy that seeks to exploit pricing inefficiencies in a firm's capital structure. Strategy will entail a long position in the undervalued security, and a short position in the overvalued, expecting the pricing disparity between the two to close out.
CONVERTIBLE ARBITRAGE: Involves the purchase of convertible securities, generally convertible bonds, coupled with the short sale of the equities underlying these securities. This position hedges out the equity risk, captures leveraged cash flows and exploits the volatility contained in the convertible’s embedded option.
CLOSED FUND: A hedge fund that has temporarily or permanently stopped accepting new capital from investors.
DISTRESSED SECURITIES: Investments in securities of companies where the security's price has been, or is expected to be, affected by a distressed situation. This may involve reorganizations, bankruptcies, distressed sales and other corporate restructurings.
EQUITY HEDGE: Consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options.
EQUITY MARKET NEUTRAL: Seeks to profit by exploiting pricing inefficiencies between related equity securities, neutralizing exposure to market risk by combining long and short positions.
EVENT DRIVEN: Involves investments in opportunities created by significant corporate events, such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks.
FIXED INCOME ARBITRAGE: Investment strategy that seeks to exploit pricing inefficiencies in fixed income securities and their derivative instruments. Typical investment will involve a long position in a fixed income security or related instrument that is perceived to be undervalued, and a short position in a similar, related fixed income security or related instrument. Fixed income arbitrage includes basis trading, inter-market spreads, yield curve trading, relative-value options and financing strategies.
HEDGE FUND: A variety of pooled investment vehicles loosely regulated and not registered under federal securities laws as public corporations, investment companies, or broker-dealers. Hedge funds differ substantially in their investment objectives, use of different financial instruments, exposure to various markets and risk and return objectives. Other generally accepted attributes include the ability to use leverage, use of short sales to mitigate or increase risk and performance based compensation schedules.
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Appendix: Glossary (cont’d)
HEDGE FUND OF FUNDS: An investment company that invests in hedge funds - rather than investing in individual securities.
HIGH WATERMARK: The highest peak in value that an investment fund has reached. This term is often used in the context of fund manager compensation. For example, a $1,000,000 investment is made in year 1 and the fund declines by 50%, leaving $500,000 in the fund. In year 2, the fund returns 100%, bring the investment value back to $1,000,000. If a fund has a high watermark, it will not take incentive fees on the return in year 2, since the investment has never grown. The fund will only take incentive fees if the investment grows above the initial level of $1,000,000.
HURDLE RATE: The minimum investment return a fund must exceed before a performance allocation/incentive fee can be taken.
INCENTIVE FEE: The fee on new profits earned by the fund for the period. For example, if the initial investment was $1,000,000 and the fund returned 25% during the period (creating profits of $250,000) and the fund has an incentive fee of 20%, then the fund receives 20% of the $250,000 in profits, or $50,000.
LEVERAGE: Money borrowed to increase the amount of money invested to more than 100 % of the fund net asset value. Usually done to increase buying power and to increase exposure to an investment.
LOCK UP: Time period that initial investment cannot be redeemed from the fund.
LOSS CARRYFORWARD: A "carryforward" arises when a loss or tax credit is not fully used in the current period and, as a result, the unused portion may be used to offset any future capital gains.
MACRO: Involves investments in a wide variety of strategies and instruments, often assuming a directional posture based on the manager’s top-down global approach. Macro managers make bets on anticipated price movements of stock markets, interest rates, foreign exchange and physical commodities.
MAXIMUM DRAWDOWN: The worst period of "peak to valley" performance for the fund, regardless of whether or not the drawdown consisted of consecutive months of negative performance.
MERGER ARBITRAGE: Involves investments in leveraged buy-outs, mergers, hostile takeovers, and other special situations, which alter a company’s financial structure or operating strategy.
MULTI-STRATEGY: Investment style which allocates investment capital to a variety of investment strategies, although the fund is run by one management company.
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Appendix: Glossary (cont’d)
NAV: Net asset value per share – the market value of a fund share. Equals the closing market value of all securities within a portfolio plus all other assets such as cash, subtracting all liabilities (including fees and expenses), then dividing the result by the total number of shares outstanding.
NET EXPOSURE: Net exposure measures how much a fund is exposed to market risk. For a long/short equity fund, if a fund is 100% long and 50% short, then the net exposure is 50%.
PAIRS TRADING: Non-directional relative value investment strategy that seeks to identify two companies with similar characteristics whose equity securities are currently trading at a price relationship that is out of their historical trading range. Investment strategy will entail buying the undervalued security, while short-selling the overvalued security.
PRIME BROKER: The principal brokerage firm with which an investment fund does business. Prime brokers may provide custodial, clearing and research services, as well as supply the stocks a manager borrows to sell short.
R SQUARED (R2): A statistical measure that represents the percentage of a fund’s or security’s movements that are explained by movements in a benchmark index.
RELATIVE VALUE ARBITRAGE: Involves the simultaneous purchase and sale of similar securities to exploit pricing discrepancies.
SHARPE RATIO: A measure of risk-adjusted return that signifies the amount of return for each unit of risk. It is calculated by subtracting the risk-free rate from the managers’ return and dividing by the standard deviation. The higher the Sharpe Ratio the better the returns are on a risk-adjusted basis.
SHORT REBATE: Managers who borrow stocks to sell short are responsible for the dividends those stocks would pay. Proceeds from short sales are typically invested in a Treasury-bill account, held with the prime broker as collateral. Depending on negotiations, much of the interest the Treasury-bill account generates is rebated to the manager.
SHORT SELLING: Involves a short position in a security; a technique used to take advantage of an anticipated price decline.
STANDARD DEVIATION: A statistical measurement of the variation of returns around a portfolio’s average return over a designated time period. Investors may examine historical standard deviation in conjunction with historical returns to decide whether a fund's volatility would have been acceptable given the returns it would have produced. A higher standard deviation indicates a wider dispersion of past returns and thus greater historical volatility. Standard deviation does not indicate how the fund actually performed but merely indicates the volatility of its returns over time.
STATISTICAL ARBITRAGE: Statistical arbitrage players use historical statistical data to identify mis-pricings among securities that have some correlation among each other and try to benefit from market movements that close the gap.
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Risks to consider when making hedge fund investment s� Limited liquidity
– invested capital is generally accessible for redemption only on a quarterly or annual basis
� Volatility
– investment strategies used by the investment adviser and/or portfolio managers, utilizing futures, options and short sales, can be highly volatile
� Loss of capital
– investors can lose up to the full amount of their invested capital
� Leverage
– hedge funds often use leverage, sometimes at significant levels, to enhance potential returns
� Dependence on manager
– the Fund’s success is dependent on the investment manager to develop and successfully implement investment strategies that meet investment objectives
� Limited transparency
– with little or no public market coverage, investors must rely on the investment manager for periodic information
� Conflicts of interest
– the investment adviser and/or portfolio managers could be subject to various conflicts of interest, which could influence how those portfolio managers invest the Fund’s assets
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