Hedge In Emerging Markets

A BRIEF HISTORY: The hedge fund industry has grown at a ferocious pace in the last decade, from as few as 300 funds in 1990 to more than 10,000 funds today. These funds have become highly visible in markets and the press, and are estimated to manage over $3 billion in assets, both through onshore and offshore funds. The very first hedge fund was started by Alfred W. Jones in 1949. By using leverage and short selling, he effectively "hedged" risk in the marketplace. Though his hedge fund greatly outperformed mutual funds of that time, hedge funds really didn't feign much interest until the 60's. Big names like Warren Buffet and George Soros took an interest in Jone's strategy, and over the next three years, 130 hedge funds were born Hedge funds, like other alternative investments such as real estate and private equity, are thought to provide returns that are uncorrelated with traditional investments. This has attracted an increasing number of individual and institutional investors who have realized that investing in hedge funds can further diversify their portfolios and produce higher returns at lower risk. While Alfred Jones' strategy employed short selling and leverage, there are a multitude of different strategies used by hedge fund managers today. The term "hedge" doesn't always apply, since many of these funds are not hedged at all.

HEDGE FUND DYNAMICS: Employing vastly different investment strategies and approaches to risk-management, hedge funds are defined by their structural characteristics, rather than their "hedged" nature. Hedge funds are primarily organized as private partnerships to provide maximum flexibility in constructing a portfolio. Hedge funds can take both long and short positions, make concentrated investments, use leverage or derivatives, and invest in many markets. This is in sharp contrast to mutual funds, which are highly regulated and do not have the same breadth of investment instruments at their disposal. While mutual funds are mainly limited to stocks and bonds, hedge funds enjoy a wide variety of investments which may include futures, PIPEs, real estate, art, even website domain names. Another feature of hedge funds is that you must be an accredited

investor or a qualified client in order to invest your money. This is one of the very few regulations that hedge funds must abide by, and is designed to protect the average middle-class investor. In addition, most hedge fund managers commit a portion of their wealth to the funds in order to align their interest with that of other investors. Thus, the objectives of managers and investors are the same, and the nature of the relationship is one of true partnership. HEDGE FUND FACTS: Hedge funds have been proven to correlate very little to traditional asset classes. In other words, when the stock market drops 10%, it is not at all necessary that hedge funds will lose as much, or even decline at all. Thus, a portfolio that includes hedge funds or any asset class whose returns depend less on the market, will benefit greatly from the added diversification. Most hedge funds primary objectives are capital preservation. Hedge fund managers have a number of risk management tools at their disposal that could help reduce downside risk. This enables them to deliver consistent returns in all market conditions. Hedge fund managers also employ investment tools that can greatly increase returns. Unlike mutual funds, hedge funds can use short selling, invest in derivatives, leverage their portfolios, and hold highly concentrated positions - strategies that can amplify returns greatly. In fact, composite hedge fund indexes have consistently equaled or beat the aggregate market indexes (such as DJIA and Russell 2000) in the last five years. The fact that hedge funds can provide high returns at lower risk is not a contradiction. In general, hedge funds offer higher risk adjusted returns than traditional investments. As exemplified by the hedge fund indexes, pooling hedge funds into portfolios can significantly reduce their total risk. More importantly, the addition of one or more well-chosen hedge funds to an investment portfolio can add the same benefits to an investor's overall financial picture.

WHY HEDGE FUNDS?

Hedge funds have been a mystery to some and thought of as an investment device for the "Rich and Famous." Aside from the exclusivity they have enjoyed, hedge funds are in fact the choice of many informed investors. What makes hedge funds different, and thus the key to their unique ability to succeed, is their diversity. The variety of hedge fund strategies far exceeds anything offered by a traditional mutual fund or stock broker. The strategies tend to be more niche-like in their approach and frequently, much less dependent upon the market for returns. Investors also prefer to invest in Hedge Funds because the fund managers have a direct interest in the positive performance of their funds. Hedge fund managers are compensated largely based upon how well they perform and in many cases the fund manager is also one of the key investors in the fund. These are two very strong incentives for the fund managers and possibly why many Hedge Funds will achieve their goals while other investment vehicles may not. HEDGE FUND STRATEGIES IN EMERGING MARKETS:

130/30 strategy: As equity markets become more efficient, managers are seeking new strategies that can deliver Consistent alpha (excess return over their benchmarks). Strategies such as 130/30 portfolios, which are among the most recent and most discussed, are receiving significant asset inflows. Investors are increasingly considering 130/30 strategies as an alternative to long-only portfolios because: 1. Managers can take larger active weights in individual holdings, specifically when underweighting stocks 2. Assuming the manager is skillful, the risk-adjusted excess returns should be higher than a long-only strategy 3. The benefits of constrained shorting is palatable to some investors with limited experience Investing in long/short equity strategies Although the ability to short stocks can benefit a portfolio, these strategies have some significant Drawbacks, which include:

1. Managers lacking experience shorting stocks 2. Identifying short positions may require a different investment process and additional operating and technology commitments than long-only strategies 3. The strategy is in its infancy and evidence of success is limited 4. A majority of 130/30 strategies focus on large cap stocks, one of the more efficient areas of the market 5. For fundamental-based managers, implementation of 130/30 strategies requires a substantial change to their investing process Given the questions surrounding 130/30 strategies, FEG believes institutional investors should consider allocating to long/short hedge funds and portable alpha strategies, as these funds eliminate some of the drawbacks associated with 130/30 strategies.  130/30 Defined 

Although most frequently characterized as 130/30 strategies, investors may recognize these as: • 120/20 or 140/40 strategies • constrained long/short equity strategies •enhanced active equity strategies • extended equity portfolios Regardless of what investors call the strategy, the intention is to allow managers to meaningfully underweight stocks relative to the appropriate benchmark by introducing limited shorting to the process and investing the proceeds in long positions to generate additional alpha. By removing the constraints of long-only portfolios, investment managers are better able to implement their insights on the expected return of stocks. Although the managers employ different processes to generate the stocks they hold long and short, each strategy takes a short position in a specified percentage of the portfolio (e.g., 30%) and goes long in the same percentage (e.g., 30%). Thus, a 130/30 strategy will have a 30% short exposure, which is reinvested in the long portfolio to generate a 130% long exposure. As illustrated in the chart below, the 130/30 portfolio structure, however, will maintain a 100% net equity exposure to the market, similar to a long-only manager

The use of leverage in a 130/30 strategy is a key difference from a long­only portfolio. There is a  risk  associated   with   the   use   of   leverage   because   an   investor   is   reinvesting   funds   that   were  generated from selling short  securities. Instead of buying  S10,00,000 of stock in a long­only  portfolio, in a 130/30 strategy, $10,00,000 is invested in long positions, $300,000 worth of stock  is borrowed and sold short, and the $300,000 in proceeds is invested to extend exposure in the  long portfolio (refer to the table below). The use of leverage in the portfolio can be beneficial  should the manager exhibit skill in selecting stocks to short and long. Leverage, however, can  magnify the consequences of a manager’s poor selection

             Cash Flows for a $1,000,000 Allocation to a 130/30 Portfolio

The structure of 130/30 strategies is intended to reflect the risk of the benchmark. Rather than 

allowing the beta exposure to fluctuate based on the number of long positions relative to the  number of short positions in a long/short hedge fund, 130/30 portfolios target a beta of 1.00 to  mimic the risk characteristics of the benchmark. Not all 130/30 strategies will have betas of  exactly 1.00 at all times but they will consistently be in a range close to 1.00. Certain managers  constrain beta within 0.90 to1.10, while other managers maintain a beta within a tighter range of  0.95 to 1.05. In addition to managing risk by constraining beta, managers also monitor  capitalization and sector biases, which can significantly affect risk relative to the benchmark  130/30  History and Development:    

Capitalizing on the ability to short stocks is not a new idea, as the first hedge fund used shorting  and was created in 1949 by A.W. Jones and these strategies have become more popular over the  past 10 years. The structure of 130/30 strategies, however, is relatively new. Much of the research  behind 130/30 strategies, and the rational for removing the long­only constraint on equity  managers, centers on research conducted on the information ratio of various portfolio structures.  The information ratio measures the excess return generated by an investment manager to the  amount of risk the manager takes relative to a benchmark (tracking error). 

In 1989, Richard Grinold introduced the fundamental law of active management that detailed  how tomeasure the efficiency of a manager, as measured by the information ratio.Roger Clarke, 

Harindra de Silva, and Steven Thorley revisited this research and published Portfolio Constraints   and the Fundamental Law of Active Management. They determined Grinold’s work did not factor  in portfolio constraints and their impact on the information ratio. To address this issue, Clarke, de  Silva, and Thorley’s research included a measure of a manager’s ability to forecast future  securities’ returns and the ability then to implement investment ideas. They termed these  measures as follows • •

Information coefficient: Ability to forecast future returns Transfer coefficient: Active weights (manager’s investments that differ from the  benchmark) 

They also presented an example of an unconstrained portfolio and its transfer coefficient relative  to the same portfolio with various constraints. The results of this example follow:  •

The long­only constrained portfolio had a lower transfer coefficient (0.58) and a lower  information ratio (0.87) for the same level of active risk (tracking error) ­ the risk due to  active management decisions in a portfolio (refer to the following chart)

•

The unconstrained portfolio (with the ability to short stocks) had a higher transfer  coefficient (0.98) and a higher information ratio (1.47) relative to the long­only portfolio  (refer to the following chart)

This research illustrates that as the long­only constraint is loosened, skilled equity managers  should be able to generate better risk­adjusted returns, as measured by the information ratio.  Further research has been conducted by investment managers to determine the optimal short  position for these strategies. For example, the chart below illustrates that for a 2% tracking error,  the majority of the increase in the transfer coefficient from a long­only portfolio (0.40, the  smallest transfer coefficient) to a market­neutral strategy (0.67, the largest transfer coefficient)  was captured by a 130/30 structure (0.59)The increase in the transfer coefficient, therefore,  generated a higher information ratio for 130/30 and market­neutral strategies than a long­only  strategy. 

Other managers have generated similar research based on each manager’s investment process to Determine the optimal structure for its portfolio. Most of this research has concluded that  somewhere near 130/30 provides the largest marginal increase in the transfer coefficient. A  100/100 market neutral or unconstrained hedge fund maximizes the information ratio and  transfer coefficient for a truly skillful manager

Growth in 130/30 Funds: The research that demonstrated the improved efficiency of returns that can be expected from relaxing the long-only constraint has spurred tremendous growth in 130/30 fund offerings. According to data reported in the eVestment Alliance database, asset growth for managers who report to the database in U.S. 130/30 offerings increased from $2 billion as of December 2004 to nearly $37 billion as of December 2007.

In addition to the increased level of assets flowing into domestic 130/30 funds, the number of offerings has also grown substantially. Since 2003, the number of offerings populating the 130/30 universe in the eVestment Alliance database has increased from 8 to 65. Growth in 130/30 Offerings

Much of this growth has been driven by traditional long-only managers offering the strategy, but hedge fund managers are also entering the 130/30 market. Hedge fund managers introducing 130/30 portfolios are taking advantage of existing skills with long/short equity or market neutral strategies to compete against traditional long-only managers. The demand for 130/30 offerings has come primarily from those investors, pension plans for instance,who avoided hedge funds in the past. These investors traditionally avoided or were restricted from investing in hedge funds due to concerns about leverage, high fees, and the fact hedge funds are difficult to benchmark. Many institutions investing in 130/30 strategies have had little, if any, investment in long/short equity hedge funds. For a considerable number of investors, this is their first experience with shorting and a potential step toward investing in long/short equity hedge funds. Because these investors want to maintain portfolio risk characteristics similar to long-only strategies, the following comparison mainly focuses on the advantages and disadvantages of a 130/30 strategy relative to a long-only equity portfolio.

Advantages: FEG believes that there are three clear advantages to the 130/30 structure versus a long-only portfolio, which are described below. 1. Managers can take larger active positions in the smaller index constituents Investment managers have the ability to meaningfully express negative views on specific stocks

by taking larger active weights relative to the benchmark in a 130/30 fund than in a long-only strategy. Long-only portfolios limit active equity managers to underweight stocks only by the weight of that stock in the index. For example, large cap managers can underweight approximately 80% of the stocks in the S&P 500 Index by only 0.25% points or less.4 Through 130/30 portfolios, managers have a greater ability to express their negative views on individual companies by shorting those stocks within the constraints of the 130/30 structure. The ability to short stocks can allow 130/30 managers to better express negative opinions and views on companies, which in a long-only portfolio could only be underweight by their weight in the benchmark (refer to the chart below).

2. Assuming managers are skillful, the information ratio for a 130/30 strategy should be higher Relative to a long-only portfolio

Investors should expect a higher information ratio for 130/30 portfolios relative to long-only portfolios, while maintaining a beta of approximately 1.00 and 100% net equity exposure. The expected improvement in the efficiency of the portfolio is a result of loosening the long-only constraint. The ability to sell stocks short in a 130/30 strategy increases the breadth of active weights, as Richard Grinold illustrated in The Fundamental Law of Active Management. Grinold demonstrated the information ratio is driven by two factors, manager constraints and manager skill. A long-only constrained portfolio hinders a skillful manager from fully expressing negative views on certain stocks, thus preventing a more efficient portfolio structure. 3. Investors may prefer constrained shorting if they lack experience with long/short strategies Some investors have been hesitant to utilize long/short equity strategies due to the use of leverage, higher fees, and potential for limitless losses from increasing values of shorted stocks. The 130/30

strategy provides investors a constrained portfolio that should have similar characteristics to longonly portfolios.

Disadvantages Although 130/30 strategies have some clear advantages relative to long-only portfolios, there are also certain disadvantages, which are described below. 1. Lack of experience with shorting stocks Many of the traditional long-only managers introducing 130/30 strategies do not have significant experience shorting stocks. When selling stocks short, experience is important because of the different effect leverage can have on a portfolio. In a portfolio of stocks sold short, if the price movement goes against the manager, the short positions become a larger part of the portfolio and theoretically there is no limit to the amount of the loss. Whereas in a long-only portfolio, if a stock moves against the manager, the exposure to the stock declines and only the amount of the initial investment can be lost. 2. A manager’s least attractive long ideas are not necessarily the best short ideas In many cases, investment managers use the same process to identify both long and short positions for 130/30 strategies. The majority of long-only managers that initially entered the 130/30 universe utilized quantitative processes that ranked every stock in the universe and identified potential short positions using the same process. Even though a long-only manager who uses a quantitative process can identify stocks that are unattractive based on its model, these stocks are not necessarily securities that the manager should sell short. Merger and acquisition activity is a good example of a factor that is difficult to quantify and can negatively affect a stock sold short. If a company is acquired, typically it is at a premium to the current stock price, which negatively impacts the short positions in that stock. 3. A majority of 130/30 strategies have limited track records Investors must rely heavily on backtesting and hypothetical research for many 130/30 strategies,due to the limited track record for most managers. Of the 130/30 managers in the eVestment Alliance database, almost 80% have track records of less than three years (refer to the following chart). Because these are relatively new strategies, understanding how each manager constructs its 130/30 portfolio is important. An investment manager should have a clearly defined process for identifying both long and short positions. A clearly defined and consistent

process should allow investors to understand how the portfolio should perform in different market conditions.

4. Most 130/30 strategies focus on large cap stocks

Over the long-term, indexing the large cap exposure in a portfolio has demonstrated higher returns than the majority of active managers. This is evident when comparing the S&P 500 Index returns to large cap equity managers over rolling 10-year periods. The S&P 500 Index consistently performed near the top quartile of large cap equity managers over these time periods, which indicates long-only managers have difficulty outperforming the S&P 500 Index.5 For the managers that underperformed the S&P 500 Index, constrained shorting could amplify the underperformance. Management fees for 130/30 strategies also tend to be higher than longonly strategies, which could hinder a manager’s ability to generate returns in excess of the S&P 500 Index net of management fees. The average fee for large cap 130/30 strategies who reported to the eVestment Alliance database was 0.81% versus 0.71% for large cap long-only managers. Less efficient areas of the market, such as international and small cap, may offer better opportunities to generate excess returns through a 130/30 strategy. The key concerns in these markets, however, are whether the data is good enough to utilize, whether the manager could research all of the stocks, and whether the trading and shorting costs would dilute any benefits. References: “The Return of Depression Economics”, by Paul Krugman • “The Truth about Hedge Funds”, by P. Osterberg and James B. Thomson

• “Risk Management Lessons from Long Term Capital Management”, Philippe Jorion, June 1999. • “Alternative Software Development - Hedge-Funds - Finance Software - Free simulation” • “A Primer on Hedge Funds”, William Fung and David A. Hsieh, August 1999. • “The Coming Evolution of the Hedge Fund Industry: A Case for Growth and Restructuring”, RR Capital Management Corporation, KPMG Peat Marwick LLP, March 1998 • “The Eve of Destruction”, by David Shirreff • Webliography o www.fraternityfunds.com o www.E-Hedge.com o www.hedgefundresources.com

Green hedge funds: ENERGY HEDGE FUNDS have been mostly a North American phenomena until this year with the vast majority located in the New York metropolitan area. However, our continuing research into the secretive world of energy hedge funds is revealing evidence of a next wave of interest in Europe as well as an extension of the commodity trading platform into green markets. Specifically, this involves carbon trading, renewable energy credit trading, ethanol trading and emissions trading. The approach, like in all emerging markets with little price discovery, is to find arbitrage opportunities and a mis-match in pricing. This can be as simple as going long carbon in the hope that its value rises over time and as sophisticated as playing the ‘regulatory arbitrage’ of ’shorting’ renewable energy credits in one state and ‘buying long’ in another. (Some 19 states have Renewal Portfolio Standards in the US).In the Green Hedge Fund market, taking on the regulatory risk takes some degree of both government policy and market knowledge to be successful. Other green venues include biofuel trading such as ethanol and other plays in biomass for power generation. The more traditional hedge fund approach has been equities. Here, one newly launched green fund (New Energy Fund LP in New York) is a pure alternative energy play with investments in both the US and Europe. The current high and sustained fossil fuel prices should start driving a move to alternative energy generation globally, and in the past six months has focused much attention on the US venture capital sector on funding investment in alternative energy. Alternative energy includes not only wind and solar but also biomass, ethanol, distributed generation plays such as fuel cells and microturbines. One other emerging technology play is the rising interest in photovoltaic nanotechnology that may make radical improvements in electricity generation from the traditional 8 to 10% efficiency to 15% and much higher. Hedge funds that trade only long/short equities are beginning to dabble in the alternative energy sector. As far as we know, start up New Energy Fund LP is the only pure alternative energy hedge fund. There are others that may have a portion of their energy portfolio

in alternative energy. Some energy hedge funds intend to be involved in renewable energy project finance on a selective basis as well – where they may fly solo or club deals. Another reason for this new flurry of activity is that the returns for all 8100 plus hedge funds during 2004 were very unimpressive – at around 8%. Hedge fund investors demand more and now like the energy arena. Private investors, not institutions, are starting to extend their investments into emerging environmental financial markets. Some energy hedge funds were up 40-50% last year and one is rumoured to have been up 100% and returned money to investors in October (but we cannot confirm that). Other more conservative energy hedge funds are looking for 15%+ returns on a sustained basis. It’s the more entrepreneurial funds seeking higher returns that are interested in the environmental or Green Trading arena. The more developed environmental financial markets for sulphur dioxide (SO2) and nitrous oxide (NOX) trading have also attracted some hedge fund interest, as well as Wall Street interest in the recent past. It is not well known but commodity powerhouse Morgan Stanley is now the largest emissions trader in the SO2 markets – the largest most developed market of its kind in the world. Wall Street firms have told us that they will wait for more liquidity in carbon markets before jumping in but their purchase of generation assets has already given them both a ‘carbon footprint’ as well as an emissions footprint. Highly successful Houston based energy hedge fund Centaurus has been known to trade both SOX and NOX markets and are making good profits. NOX emissions, used to reduce urban ozone emissions, traded as high as US$ 40,000 per ton in the Houston/Galveston NOX markets last summer.The more mature SO2 markets for acid rain reduction got an adrenalin boost in North America last year when coal burning increased due to the high cost and under supply of more environmentally friendly natural gas. With recent trades staying at the US$ 700 per ton level for SO2 allowances, the market has now indicated that gasification technologies for coal may now be economic. With a carbon reduction regime a certainty in the US – despite the present stance of the Bush Administration – Integrated Gasification Combined Cycle (IGCC) projects have proliferated in the past several months with about 20 such projects in the pipeline. Last spring there were none. Hedge funds are known to trade the California RECLAIM market for SO2 and NOX reductions there. They are highly successful due to confusion over the rules and a proposed tightening of air quality standards in Southern California. Despite the lack of the Kyoto stamp, there are developing carbon markets in the US as well as Europe. Trades of over 1 million tons have taken place with Gulf Coast utility Entergy in December 2004. More CO2 trades are in the pipeline with a link to carbon sequestration and enhanced oil production that uses ‘commodity’ CO2 for oil field projection through CO2 injection. There is also increased activity and higher prices on the Chicago Climate Exchange (CCX) due to market changes in Europe. It is now rumoured that about 10 carbon hedge funds are in formation in both the US and Europe. Their launches are primarily due to the implementation of the Kyoto Protocol (February 16th) and the launch of the EU Emissions Trading Scheme (ETS) on January 1st. Carbon is trading at about US$ 2 per ton in the US on the CCX (way under market value). But the green hedge funds are a little smarter than that. They are looking at carbon arbitrage plays throughout the world. Their trading strategy is basically buy now at low prices and sell those credits in the future. In the EU, while we saw over 9,000,000 tons of carbon trade in January 2005, it should be noted that global carbon emissions per year top 24 billion tons of CO2. The beginning of a global carbon market is now emerging with all the attendant risks of emerging markets i.e., little price discovery, low liquidity and wide arbitrage opportunities. It’s the trading arbitrage mindset of the funds that is driving this change. One green hedge fund manager told us that an investor asked him if he was an environmentalist. He replied that he was a trader. The investor said,

“Good. I’ll give you the money.” This is a pure trading mentality not an altruistic way of saving the world. That’s what traders do. Seek arbitrage opportunities and exploit them. They have now found them in the global carbon markets. I recently met with investors in New York who invest in as many as 70 different hedge funds. They are investing in green trading markets because they basically see it as a diversification play for their fund portfolios. They like opaque prices and high returns. The downside risk is that the knowledge base of fund traders is limited in these emerging commodity markets since it requires both an industrial knowledge of trading but also a regulatory policy knowledge of government. For these are not true commodity markets but hybrid markets where governments and supranational bodies set the standard and industry reduces its emissions footprint over time. In the US SO2 market, the federal government has set up a 35 year regime for sulphur dioxide emissions reductions through to the year 2030. And contrary to the popular opinion in Europe that the US is doing nothing because of its opposition to the Kyoto Protocol, in fact the US is moving to more stringent standards on SOX and NOX (it already has the most stringent in the world), but also will be controlling mercury levels using market-based trading solutions. Furthermore, every manager of a US power plant, industrial facility or other stationary source of pollution knows that a carbon regime is forming. In fact, 28 States in the US have some sort of GHG initiative underway. The funds, being pure traders, will also exploit the carbon rules between States as they are doing in renewable energy markets. More recently, two more ‘green hedge fund’ plays are underway. One is to trade sugar as a surrogate for ethanol trading as these markets are more developed. This will bring in soft commodity giants such as Cargill and Louis Dreyfus. The other new interest that is following carbon market development (although still nascent) are water hedge funds. Here they trade longdated water rights in the Western US to start as water is now becoming a commodity, 10 years after Enron’s ill fated foray into water trading through Azurix, (although not a pure commodity play). The other interesting point is that the interest in green hedge funds is accelerating from all quarters – including Asia. Investors want returns and are now focusing beyond the energy complex in year 2 of the energy and environmental hedge fund play. All we can recommend is ‘buyer beware’ since emerging markets have all the attendant risks