Hedge Fund 220605 ML

RIC
22 June 2005
Anil Suri Alternative Investments Wealth Management Strategy (1) 212 449-1196
Introduction to Hedge Funds

An Alternative Investment Series
Global
Alternative Investments
We analyzed historical hedge fund index returns and found that they did provide a better risk-reward tradeoff versus stocks and bonds with moderate to low correlation with these asset classes. We also found high variability between styles of hedge funds and note that the nature of hedge funds is such that there could be high variability between individual funds within each style. We emphasize that this is only a historical analysis (covering Jan-94 to Apr-05) and not indicative of returns from individual hedge funds, or of future returns from the universe of hedge funds. What are Hedge Funds and what are their characteristics?
A hedge fund is a commonly used term that usually, but not exclusively, refers to a privately held entity, typically a limited liability entity, that executes one or more professionally managed active investment strategies (such as equity longshort). As of the end of 2004, one industry source (Hedge Fund Research, Inc.) estimates there were about 6,000 hedge funds globally with approximately $1 trillion of assets under management and an additional 1,700 funds of hedge funds. Given the increase in public awareness regarding hedge funds and more accessible investment opportunities for eligible individual investors, we provide a basic primer for clients to understand the potential advantages and risks of these investment vehicles. The purpose of this report is to provide background education on this topic for investors who want to learn more about hedge funds. We have written this primer mainly from a US investors point of view to address the universe of unregistered investment companies known as hedge funds. We discuss the salient characteristics of hedge funds and describe the investment styles and strategies hedge funds follow. We then examine the historical data using robust statistical techniques and concepts. We do not provide guidance on any implementation-related topics that would be important in any investment decision, such as expected forward-looking returns and the selection of hedge fund managers. Remember, US hedge funds are structured to be lightly regulated, primarily because they are offered only to a very limited group of legally eligible investors. For individuals, this translates to a very high minimum net worth requirement. In addition, many funds require a significant minimum investment. The lighter regulation gives hedge funds important competitive advantages, such as portfolio management flexibility and fee structure flexibility. However, there are also numerous differences between hedge funds and traditional investment vehicles, such as the restricted availability of comprehensive information, the level of transparency into hedge fund portfolio positions and the pace at which investors can allocate or withdraw money from hedge funds.
Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Refer to important disclosures on page 40.

Global Securities Research & Economics Group
RC#40417303
Introduction to Hedge Funds 22 June 2005
CONTENTS
n Section Introducing Hedge Funds 1. Size And Growth of Hedge Funds 2. Salient Features of Hedge Funds 3. - Sources of Competitive Advantage - Hedge Funds Use Leverage - Hedge Funds Are Less Liquid Than Other Investment Structures A Framework for Sources of Hedge Fund Returns Hedge Fund Styles Funds of Hedge Funds Historical Performance of Hedge Fund Strategies Hedge Funds Generated a Wide Variety of Returns Hedge Funds Took on a Wide Variety of Risks The Historical Risk-Reward Tradeoff In Hedge Funds Was Favorable - Hedge Funds Had Moderate To Low Correlation with Traditional Assets Page 3 5 8
Hedge Fund Investment Strategies 4.
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What Weve Learned 5. Appendix 6. Defining an Investment Strategy The Implications of Portfolio Management Flexibility Addressing Serial Correlation Addressing Downside Risks Results Using The CSFB/Tremont Family of Indices Persistence Amongst Strategies
25 26
Glossary 7.
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1. Introducing Hedge Funds

Hedge funds execute active investment strategies and have historically been structured by their managers to be lightly regulated by authorities such as the SEC in the US.
Over time, hedge fund has come to refer to a class of lightly regulated and actively managed investment vehicles. The hedge part of the term can be misleading, because not all hedge funds use hedging strategies. Hedge fund usually refers to a combination of a legal entity or investment structure (usually a private Limited Partnership or a Limited Liability Company) and one or more professionally managed active investment strategies (for example, Equity LongShort investing.) Hedge funds are lightly regulated primarily because they do not operate as US registered investment companies. As such, they can only be offered to a well defined group of eligible investors who are either institutional investors or very high net worth individuals. In the US, access to hedge funds is typically gained by becoming a limited partner (LP) in a Limited Partnership or through investing in a Limited Liability Company (LLC). Normally, the hedge fund is a separate and distinct legal entity from the hedge fund manager who manages and advises the hedge fund. As lightly regulated entities, hedge funds have operated with considerable portfolio management flexibility under relative anonymity. Even the recent SEC changes mandating certain hedge fund managers to become registered under the Investment Advisors Act of 1940 by February 2006 have still afforded hedge funds their portfolio management flexibility. Despite limited investor eligibility, hedge funds have recently attracted substantial assets under management. As of the end of 2004, Hedge Fund Research Inc. (HFRI) estimates put hedge fund assets at about $1 trillion with about 6,000 hedge funds in operation globally. At that time there were about 1,700 funds of hedge funds in operation. Investors have been drawn to hedge funds perhaps because of their apparently attractive historical performance characteristics: 1. High historical returns: The HFRI Fund Weighted Composite, an equally weighted index of hedge fund performance, indicates that these funds returned 11.34% annualized, after fees, between January 1994 and April 2005. This compares with 10.31% for the S&P 500 index (henceforth referred to as Stocks) over the same horizon and 6.62% for the Merrill Lynch US Domestic Master Fixed Income Index (henceforth referred to as Bonds). Relatively low historical volatility: Over the same period, the HFRI Fund Weighted Composite index returns had an annualized standard deviation of 7.19%, in between the 15.10% standard deviation of Stocks and the 3.95% standard deviation of Bonds. Moderate to low historical correlation: HFRI Fund Weighted Composite index returns had a correlation of about 0.7 with Stocks and about zero correlation with Bonds over the same horizon.
Historical performance shows relatively attractive returns, as well as desirable portfolio characteristics such as low standard deviation and relatively low correlation with equities and fixed income.
2.
3.
This combination of relatively high returns, low volatility (standard deviation of returns a statistical measure for risk) and moderate correlation with traditional asset classes, such as Stocks and Bonds, can be very appealing from a quantitative asset allocation point of view. However, this attractive risk-reward profile is not a free lunch. There are numerous differences between hedge funds and either traditional asset classes such as Stocks and Bonds or other more regulated investment vehicles such as mutual funds. A portion of the performance advantage of hedge fund indices may also be due to hedge fund database biases.
Important features of hedge fund investments are summarized below.

Exhibit 1: Key Features of Hedge Fund Investments
Lighter regulation Hedge funds have historically been structured to be largely exempt from the registration, reporting, record-keeping and disclosure requirements of regulatory authorities such as the SEC in the US. Although more hedge fund managers will be required to register starting Feb-06, as unregistered investment vehicles, hedge funds will still retain most of the portfolio management flexibility they now enjoy, but will, as they always were, still be subject to the anti-fraud provisions of SEC regulations. Hedge funds can only be offered to legally eligible investors. For individuals this usually translates to a very high minimum net worth requirement. In addition, many hedge funds require significant minimum investments. Since hedge funds have historically been lightly regulated, they were not required to report their results to any public authority. As such, there is no centralized and definitive repository of data about their returns. The available historical data is limited because it is provided voluntarily, creating several biases in returns. Hedge funds, unlike mutual funds, are not required to disclose the positions in their portfolios to their investors on a regular basis, making it difficult to achieve similarly standardized levels of transparency. Additionally, as private investment vehicles, hedge funds do not advertise or disclose their returns to the general public. Hedge fund return histories are quite short (about 15 years of data), while histories of stocks and bonds span multiple decades. This gives investors less confidence in how hedge funds would respond to slow or persistent structural changes in the economic and regulatory environment they operate in. Hedge funds and funds of hedge funds (FoHF) have limitations on when money can be allocated and withdrawn from such investments. Hedge funds generally use leverage in generating their returns, which creates the potential for higher risk and return. Many hedge funds attempt to profit through short sales of securities. Short positions have different and potentially higher risks than long positions. Many hedge funds use derivatives, which introduce the potential for rapidly escalating risks and returns in a portfolio. Hedge funds typically have very flexible investment mandates. They can run concentrated or dynamically changing portfolios and many hedge funds do both. They are generally not explicitly benchmarked to broad market indices. Therefore their returns can be quite different from those of broad indices of the underlying markets hedge funds participate in. Many hedge funds rely on investment manager skill to generate a portion of their returns. Purely skill based returns pose fundamentally different risks over very long investment horizons from diversified market exposure based returns. Over such horizons, diversified market exposure delivers a premium for bearing undiversifiable risk, whereas purely skill based returns are subject to imitation, competition, over-exploitation and obsolescence. As such, skill based returns rely on continuous innovation over very long horizons and emphasizes the importance of manager selection. Hedge funds charge a performance fees over and above any management fees and sales charges. All comparisons should be based on performance after the effect of fees. Many hedge fund strategies require active trading and generate their returns via short-term capital gains. In addition, hedge funds reinvest rather than pay out such gains. This can create additional tax liability for taxable investors. Investors should consult a tax advisor for further details. In order to avoid regulation as an investment company by the SEC and offer tax favored returns to US tax-exempt investors by avoiding Unrelated Business Taxable Income (UBTI), many hedge funds are organized under tax-friendly foreign jurisdictions. However, such funds cannot be offered to US individual investors.
Restricted access Lack of standardized industry-wide reporting Lower transparency
Shorter data histories
Lower liquidity Use of leverage Use of short positions Use of derivatives Flexible investment mandates
Skill based returns
Higher fees Tax issues
Jurisdictional issues
Source: Merrill Lynch
After making a number of adjustments to the standard statistical measurements of volatility and correlation of hedge funds, which reduce the favorable performance characteristics of hedge funds, we find that many hedge fund strategies still provided an attractive risk-reward tradeoff in the historical period examined.
Hedge funds are not appropriate for investors who cannot, or will not, bear the different nature of risks in these investments. However, our historical analysis shows that they would have been attractive investments for those who can bear these different risks.
Therefore, we believe hedge funds would not have been appropriate for those investors who did not have the ability or willingness to bear the substantially different nature of risks in hedge funds. However, for those investors who could bear these different risks, our analysis shows that hedge funds did provide an attractive risk-reward tradeoff and including hedge funds in an otherwise traditional portfolio did have the potential to result in a better portfolio. This primer examines historical hedge fund data at an aggregate (i.e., index) level. Index level returns can be substantially different from returns of individual hedge funds. Therefore, individual fund manager selection is an important activity not discussed in this primer. Index level returns diversify away the idiosyncratic risk posed by individual managers and ignore important manager selection issues such as evaluation of operational risk. This primer also does not provide forwardlooking conclusions or recommendations about hedge fund performance in aggregate or about asset allocation.
2. Size and Growth of Hedge Funds

The first known hedge fund was started by Alfred Winslow Jones in 1949. Hedge funds operated in relative anonymity until the late 1980s, when the interest in such funds began to broaden. Based on industry estimates, there were 530 hedge funds in existence in 1990 ($39 billion in assets under management). At the end of 2004, there were an estimated 6,000 funds with close to $1 trillion in assets. HFRI estimates that as of the end of 2004, there were 5,782 hedge funds in operation globally with $973 billion in assets under management. These figures do not include funds of hedge funds (FoHFs) which make investments in other existing hedge funds. HFRIs data shows that as of the end of 2004, there were 1,654 funds of hedge funds globally with an estimated $359 billion under management.
Chart 1: Growth in Hedge Fund Assets
1,200
Chart 2: Growth in Number of Hedge Funds

7,000
1,000
Compound Annual Growth Rate = 24%
973
6,000
CAGR = 18%
5,782 5,065
820 800 Assets, $ Billion

Number
5,000
4,598 3,904 3,335 3,102
626 600 456 400 257 200 39 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Year 58 96 168 167 186 368 375 491 539
4,000
3,000 2,392 2,006 2,000 1,277 1,000 530 0 937 694 1,654
2,848 2,564
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Year
Source: HFRI (www.hedgefundresearch.com*); Note: Excludes Funds of Hedge Funds *Merrill Lynch makes no representations or warranties whatsoever as to the data and information provided in any referenced website and shall have no liability or responsibilty arising out of or in connection with any referenced website.
Source: HFRI (www.hedgefundresearch.com); Note: Excludes Funds of Hedge Funds
The hedge fund industry is relatively concentrated. According to Institutional Investor magazine, the top 200 hedge fund families accounted for about $546 billion in assets as of the end of 2003 (latest available data). Combining this with data from HFRI presented above, we estimate that the top 200 hedge fund families account for about two-thirds of hedge fund assets under management. However, the hedge fund industry is not as concentrated as the US mutual fund industry. The Investment Company Institute estimates that the top 25 mutual fund complexes in the US accounted for 74% of mutual fund assets under management in 2004, essentially unchanged from 2000. The point however is that a small proportion of hedge fund families account for most of the assets managed by such investment vehicles.
Hedge fund databases have important limitations, specifically: voluntary reporting (self-selection bias); deletion of returns from defunct funds (survivorship bias); and a comparatively short history.
Since hedge funds are not registered as investment companies, they are not required to report results to any public authority. Therefore, there is no centralized and definitive repository of hedge fund data. However, many private data providers collect data about hedge funds although these databases are neither mutually exclusive nor collectively exhaustive. There are three important issues about hedge fund databases that investors need to be aware of: 1. Selection bias: Hedge fund databases are not fully reflective of the universe of hedge funds in operation. In practice many poorly performing funds, and some of the largest and most successful funds, do not report to databases. The former does not report in order to avoid adverse publicity. The latter does not report because these funds are usually closed to new investors and they are not looking to raise new assets. In contrast, newer funds with attractive track records that are still looking for capital have a strong incentive to report their results to several databases. Additionally, databases often impose certain criteria such as
a minimum amount of assets under management before funds can be included in the database. However, such inclusion criteria, which reflects conservatism from the database providers point of view, does end up rendering the database less than fully reflective of the entire universe of hedge funds in operation. 2. Survivorship bias: When the entire historical performance of defunct funds is deleted from the database, the average returns of the remaining funds, i.e., the survivors, look better over time because defunct funds are generally poor performers. Studies have estimated that survivorship bias inflates the historical average returns of hedge fund databases upwards by about 1% to 3% per year. Note that these figures refer to the database and not necessarily to an index of returns created from such a database. The hedge fund indices we examine in this report have a policy of not restating their historical returns if funds in the index become defunct. Therefore, these indices are largely free of survivorship bias in the period we examine (Jan-94 to Apr-05.) Data quantity and quality constraints: Hedge fund data is not fully comparable to that of traditional investments due to a lack of standardized reporting guidelines and histories that do not span multiple business cycles.
3.
Selection bias can be somewhat mitigated by choosing a very large database. Although this would not overcome the bias completely, one would at least know that averages from a large sample of hedge funds would be close to the averages of the overall hedge fund population. Survivorship bias can also be partially overcome by choosing either a database or an index that has taken measures to retain the history of defunct funds. It is important to note that none of these issues can be fully overcome at the database level. In order to analyze the historical performance of hedge funds, we had to choose an index that is representative of the hedge fund universe. Commercially available hedge fund indices are created from privately managed hedge fund databases. The table below shows a sampling of the set of hedge fund indices currently available.
Exhibit 2: Overview Of Select Hedge Fund Indices
Index Provider Altvest Barclay Group CISDM CSFB/Tremont EACM Edhec Hennessee Hedge Fund Net HFRI MSCI Van Hedge Index Weighting Scheme Equal Equal Median Asset Equal Statistical Equal Equal Equal Equal & Asset Equal Index Launch Date 2000 2003 1994 1999 1996 2003 1987 1998 1994 2002 1994 Index Base Date 1993 1997 1990 1994 1996 1997 1987 1976-95 1990 2002 1988 No. of Funds in the Database 2600 2450 2300 3300 100 N.A.. 3500 2300 2300 1800 5400 No. of Funds in the Indices 2600 2053 1280 409 100 N.A. 690 2300 1600 1500 1300
Source: Edhec Risk, Merrill Lynch
Since hedge fund databases are not fully representative of the hedge fund universe, neither are any of the individual hedge fund indices. In selecting a representative index family we preferred one that had a long history at the aggregate as well as strategy level, included a large number of funds and was widely followed by hedge fund investors. We also had to choose between an equally weighted index and an asset weighted index. An equally weighted index represents the performance of the average fund whereas an asset weighted index represents the performance of the average dollar allocated to hedge funds. Since both types of weighting schemes are important in different contexts, we chose one index of each kind and did not analyze others to keep the analysis manageable for readers. In the main section of this report, we analyze an equally weighted set of indices from HFRI. In the Appendix, we present similar quantitative analysis for an asset weighted family of indices from CSFB/Tremont. We emphasize that we also ran tests to check if the average returns and volatilities of indices from the two providers were statistically different from each other and found no significant difference over the full period we examine. However, there were some differences on a month by month and annual basis.
3. Salient Features of Hedge Funds

Investment strategy and fee structure flexibility are two potential competitive advantages hedge funds have that stem from the light regulation of the investment structure (i.e., legal entity) hedge funds use. These advantages are unrelated to the level of skill currently prevalent in either hedge funds or other more regulated investment settings and are likely to persist because they are based on regulatory differences that are slow to change. Additionally, although for some time managers of a number of the larger and more established hedge funds have chosen to register as investment advisers, they have still enjoyed the competitive advantages of operating unregistered investment companies1. n Sources of Competitive Advantage
Lighter regulation of hedge funds under US securities laws leads to certain competitive advantages versus more regulated entities such as mutual funds.
A limited clientele of sophisticated investors is one of several criteria that have historically rendered hedge funds and their managers exempt from the registration requirements and extensive regulation of the US securities laws governing registered investment companies. This exemption has two important implications: portfolio management flexibility and fee structure flexibility.
Portfolio management flexibility

This allows hedge funds to freely: Utilize more leverage in their investments Short sell securities (i.e., borrow and sell securities they do not own) more so than mutual funds can Use derivatives to a greater extent Take larger positions in illiquid investments Build concentrated portfolios because hedge funds are not explicitly benchmarked to traditional stock and bond indices.
Greater portfolio management flexibility could give hedge funds a competitive advantage unrelated to the level of investment management skill in either hedge funds or more regulated entities. This flexibility enables hedge funds to cast a wider net in search of profitable investment opportunities. For example, consider an equity long-short hedge fund manager and a more regulated long-only equity investment manager with equal skill analyzing securities chosen from an identical universe. The hedge fund manager has a competitive advantage because of greater portfolio management flexibility. Although both managers will have identical opinions about the securities analyzed, the hedge fund manager will have a greater ability to execute decisions based on these opinions. Specifically, the hedge fund manger could use the same investment insights as the other manager to:
Hedge funds are able to freely execute certain investment strategies from which more regulated funds are typically restricted.
1. 2. 3.
Short sell securities on which both managers are equally negative Purchase illiquid securities both find equally attractive, but which only the hedge fund manager is allowed to purchase Position the portfolio defensively by reducing market exposure if both of them identically forecast a bear market
While the example above uses an equity long-short manager as an example, a more general point is that hedge funds have more opportunities to realize higher returns, given equal security selection skill. This advantage stems from the structure or legal entity in which the investing takes place. Hedge funds have greater flexibility because they are not as highly regulated. We already assumed
Recall that we have written this primer mainly from a US investors point of view to address the universe of unregistered investment funds; the regulatory regimes in other developed countries are somewhat different. Even when hedge funds are not privately held entities in other countries, they still retain the portfolio management flexibility that is their potential source of competitive advantage.
that both managers had equal skill in our stylized example above. The different returns come from the different portfolio restrictions these managers face in expressing their security selection views. We provide a more in-depth discussion of this topic in the Appendix.
Hedge funds typically have a performance fee (a percent of the profits) in addition to a management fee. These fees may have strategic benefits for an investor.
Fee structure flexibility

Both mutual funds and hedge funds charge investors somewhat similar management and distribution fees a percentage of the assets being managed. However, lighter regulation allows hedge funds to charge investors an additional incentive or performance fee a percentage of the gains that the fund makes. The management fee is usually in the 1%-2% per year range and the incentive fee is typically 20% of profits. Normally, a highwater mark provision is made so that losses, if any, from prior years are made whole before an incentive fee is triggered. A few hedge funds will also set a hurdle rate of return below which the incentive fee will not apply. Compared to mutual funds with the same amount of assets under management, the hedge fund fee structure generates higher revenue if returns are positive and similar revenue when returns are negative. At first glance, such a fee structure may seem excessive. However, certain factors should be considered when assessing its impact. Hedge funds typically: 1. 2. Report returns on an after-fee basis, making their results comparable across different investment structures. Generate returns mostly from active risk (defined later.) Their fees should be compared with those of other investment structures on the basis of active returns delivered net of fees per unit of active risk taken. Depend on a competitive labor market for investment professionals, where both extensively regulated entities (such as mutual funds) and lightly regulated entities (such as hedge fund managers) compete for a common pool of such professionals. The hedge fund fee structure may provide a competitive advantage in attracting proven and successful investment professionals with opportunities for significantly higher compensation.
3.
n Hedge Funds Use Leverage, But Practical Considerations
Generally Deter Excessive Use One way of gauging leverage in a hedge fund is to calculate its ratio of Gross Assets to its Net Asset Value.
Most hedge funds use some amount of leverage in generating their returns. The analysis of leverage in hedge funds is a complicated topic because of the diversity of strategies used and the many different ways of measuring leverage. There are two broad notions of leverage that are relevant for hedge funds. The first is the notion of using borrowed money to gain an economic exposure to an investment that is greater than the value of the investors cash commitment. This is called explicit leverage (also called accounting based leverage) and it is usually expressed using accounting ratios such as total assets to equity. The second notion of leverage tries to capture the ability to absorb losses and is called implicit leverage (also called risk-based leverage.) It can be expressed as a ratio of statistically estimated potential loss to equity. Both measures of leverage are important although measures of implicit leverage tend to capture the notion of leverage in hedge funds more consistently than measures of explicit leverage. This is because purely implicit leverage can be gained by using derivatives and it may not show up in purely explicit or accounting based measures of leverage.
However, in this report we will illustrate the extent of leverage in hedge funds using one of several measures of explicit leverage the ratio of Gross Assets (Long Market Value plus Short Market Value) to Net Asset Value (NAV). We do this because this measure is comparable across many situations in which leverage is used in the markets and also because data about the extent of this measure is more readily available. However, we emphasize that this is not a universal measure of leverage or of risk in hedge funds and may give conflicting signals in some cases. For example, a hedge fund portfolio that is long and short equal market values of a large number of highly correlated stocks will have high leverage according to this measure of explicit leverage. However, such a portfolio has a low risk of loss because the market values of the long and short sides will tend to move together and gains on one side will tend to offset losses on the other side. An implicit or risk based measure of leverage will correctly capture this dynamic and confirm this to be a lower risk portfolio.
Hedge funds can use more leverage than mutual funds, allowing them to deploy more dollars against an investment idea.
When investing in equities, current securities regulations permit equity investments made by hedge funds to be explicitly leveraged up to 2:1 (1.33:1 for mutual fund equity portfolios). Therefore, for every $100 in Net Assets, hedge funds have access to $200 Gross Assets in equities (mutual funds can access $133 in stocks for the same $100). Hedge funds can obtain much more leverage in equities via Joint Back Office arrangements or in assets outside of equities, for example in bonds, or via derivatives such as swaps. Leverage, however, is a double-edged sword. In theory, the hedge fund generates a higher rate of return with the same net assets, but it could also have a lower (or negative) rate of return if the investment loses money. This is because leverage amplifies both gains and losses. Some hedge fund managers use leverage in otherwise stable investments to amplify minute pricing discrepancies they may spot between similar financial instruments. These small inefficiencies are worth pursuing only with the use of leverage. This is typically the case in Fixed Income Arbitrage and Convertible Arbitrage hedge fund strategies described later in this report. Substantial leverage, from 5:1 to 10:1, is crucial to the successful execution of such hedge fund strategies. However, excessive leverage can greatly increase risks, especially in periods of market crises or liquidity shocks. If the long-run pattern of hedge fund returns demonstrates an attractive risk-reward tradeoff, then investors can infer that the use of leverage has historically been prudent.
Leverage occurs throughout the financial markets and the economy. Whats important isnt so much the use of leverage but that investors understand a hedge funds policies with respect to risk management and the amount of leverage.
Leverage is a common feature in many investment and financing settings. In order to gauge commonly occurring levels of leverage, we make two comparisons: Total Capitalization to Equity of the S&P 500 Banking sector. The 5-year trailing average value of this leverage ratio is currently 8.6:1 and was 5.5:1 on May 9, 2005. The financing decisions of homeowners. According to the latest American Housing Survey (2004), the median loan to value ratio among American homeowners is 58.7%. This translates into a leverage of 1.4:1 in our terms.
Comparing these levels of leverage with the average levels of leverage used by hedge funds is useful. Given the lack of industry-wide data on leverage, only statistical estimates of industry-wide leverage in hedge funds are available. One such study2 shows that average leverage was about 5:1 in the 1996 to 2004 period. At its peak (1997-98), average hedge fund leverage was estimated to be about 10:1. Current estimates (end 2004) put average hedge fund leverage at about 3:1.
2 McGuire, Patrick, Eli Remolona , and Kostas Tsatsaronis, Time-varying exposures and leverage in hedge funds, BIS Quarterly Review, March 2005
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It is important for investors to understand the policies and practices of the specific hedge fund they are considering, before making any investment.
What is truly important is the use of leverage in light of market developments. One way to gauge this prudent use of leverage is to examine the risk-adjusted returns from the investment. However, this may not be indicative of future leverage policy. Therefore, it is crucial that investors understand a hedge funds policy with respect to leverage and, more broadly, its risk measurement and risk management policies; particularly if it experiences a draw-down (a reduction in its NAV from a previous high). During draw-downs, increasing leverage could be one sign that the manager may be taking undue risks in order to get the funds NAV back up to its previous high. Understanding and evaluating such policies requires expertise and time. However, investors should realize that the portfolio management flexibility afforded to hedge fund managers also comes bundled with some flexibility with respect to leverage. The propensity of hedge funds to take on leverage is affected by the performancebased incentive fee. Since hedge fund managers earn a portion of the funds positive performance, they will take on leverage in investments where they have a high enough conviction in their belief about a positive outcome. However, since the performance fee is asymmetric (no negative fee in the case of losses), there may be an incentive to take on too much leverage. This is mitigated by the substantial portions of their own net worth that many hedge fund managers have invested in their fund. In this instance, they would lose personally by taking on excessive leverage. Effectively, this practice helps align the interests of the hedge fund manager with that of investors and may act as a brake on excessive leverage. n Hedge Funds Are Less Liquid Than Other Investment Structures
Such As Mutual Funds. Hedge funds are comparatively less liquid and typically impose restrictions on when monies invested can be withdrawn.
From an investors perspective, hedge funds are less liquid investments because they often impose a lock-up (an obligation to keep the money in the fund for a specified period of time from commitment, usually one year but sometimes several years). They also often require a notice period of several weeks or months before money may be withdrawn. When permitted, withdrawals are usually once a quarter. Some hedge funds may also limit the total amount of redemptions for all investors over a given period. These exit restrictions are imposed so that a hedge funds positions can be liquidated in an orderly manner (i.e., if several investors wish to exit simultaneously) and prevent forced sales of potentially illiquid securities, which would significantly lower returns. Hedge funds may also impose entry restrictions. Successful hedge funds may refuse to take new money from investors stating that they have reached their capacity. This is done to keep the size of the fund in a sweet spot small enough to remain nimble in its chosen strategy and large enough to earn enough fees to attract and retain superior talent. The net impact of these entry and exit restrictions is that hedge fund investments are generally more illiquid.
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4. Hedge Fund Investment Strategies

Hedge funds use traditional securities and derivative financial instruments in active, dynamic investment strategies that achieve a different pattern of returns from those of the markets they invest in.
Hedge funds represent non-traditional or alternative active investment strategies and typically are not explicitly benchmarked to a broad market index of traditional 3 asset classes. The goal of these strategies is to pursue high risk adjusted returns , regardless of the asset class, financial instrument or economic environment. As a result, these strategies are also called absolute return strategies. Please refer to the Appendix for a definition and discussion of investment strategies. Hedge fund strategies use securities and derivative financial instruments in traditional asset classes. However, they invest in them dynamically to achieve a very different pattern of returns compared to those from broad market indices of these asset classes. Effectively, they start with the same raw materials (i.e., financial instruments such as stocks and bonds), and transform them into a different finished product (hedge fund returns), using active investment strategies. A number of academic and practitioner studies have shown that upwards of 80% of the risk in most traditional active strategies, such as one followed by most mutual funds, is market risk. In other words, most of the variation in mutual fund returns tends to be associated with the variation in the returns of the overall market, for example the equity market for an equity mutual fund. However, our analysis of hedge fund returns shows that most of the variation in hedge fund returns, usually upwards of 50%, is not related to the variation in Stocks, Bonds or Cash4 due to what is known as active risk. We define active return as the difference between hedge fund returns and returns from an optimally tracking portfolio comprising only Stocks, Bonds and Cash. Active risk is the variation in active return; it stems from the differences in positions between these portfolios. Active risk is associated with the positions the hedge fund actively manages, not the variation in the underlying markets in which it participates. Additionally, since hedge funds use derivatives as well as dynamic trading strategies, their returns do not have a straightforward linear relationship with the returns from the underlying markets. Investment strategies that are primarily exposed to active risk are fundamentally different in a forward-looking sense than those that are mostly exposed to market risk. This is because investors require a return for bearing prolonged exposure to market risk and the auction-like, price-setting nature of financial markets is well suited to generating such a reward over very long horizons. Active risk, however, is driven by skill, opportunity and flexibility, all of which are subject to competition, exploitation, obsolescence, economic and regulatory change. As such, skill based returns rely on continuous innovation, which emphasizes the importance of manager selection.
Hedge fund strategies typically exhibit more active risk whereas traditional portfolios tend to experience more market risk.
Active risk will only be rewarded if the unique decisions of the investment manager generate positive riskadjusted returns over long horizons.
When comparing different investment alternatives, there are many ways to adjust investment returns for risk. Perhaps an intuitive method is to use the ratio of average returns in excess of cash equivalents such as 30-day US Treasury Bills to investment risk as measured by the standard deviation (also known as volatility) of returns. This ratio is known as the Sharpe ratio and it articulates the average return per unit of historical volatility in an investment. The Sharpe ratio thus makes comparisons across investments with differing volatilities possible and readers should keep this ratio in mind when we refer to risk-adjusted returns. 4 We define Cash as the return on constant maturity 30-day US Treasury Bills.
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n A Framework for Sources of Hedge Fund Returns A conceptual framework for thinking about the potential sources of return from different hedge fund styles and strategies is provided in Exhibit 3. We break down gross (pre-fees) hedge fund returns into three main constituent categories: Skill Based Returns, Market Based Returns and Alternative Risk Premia
Exhibit 3: Potential Sources of Hedge Fund Returns
Skill based returns, market based returns and alternative risk premia are potential sources of hedge fund returns.
Skill Based Returns
Hedge Fund Gross Returns
Market Based Returns
Alternative Risk Premia
Return Forecasting
Equities
Risk Transfer Premium
Relative Valuation
Fixed Income
Liquidity Premium
Operational Efficiency
Currency
Spreads
Commodities
Leverage
I.
Skill based returns: This portion of returns is derived from superior manager skill and can be grouped into 3 categories. Return Forecasting skill: The ability to generate and implement relatively accurate return forecasts at the security specific, sector, or asset class level. Forecasting skill generally stems either from more information or better processing of information, and sometimes is a combination of both. Relative valuation skill: The ability to detect mispricing and exploit inefficiencies amongst prices of similar financial instruments such as bonds, stocks, or derivatives; sometimes also referred to as arbitrage. It usually stems from better processing of information. Operational efficiency: The ability of the hedge fund manager to prioritize investment ideas, execute trades, and manage risks in an efficient and low cost manner. This skill stems from the way the hedge fund manager is organized and managed as well as from economies of scale and scope. Its importance increases as the size and scope of the hedge fund and its manager increase.
II. Market Based Returns: Returns from asset classes such as equities, bonds, currencies and commodities, without the use of leverage. This return accrues to investors primarily for deferring current consumption and bearing undiversifiable risk over long horizons. Depending on the hedge funds strategy, a negligible to significant portion of its return may be derived from this source of return.
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III. Alternative Risk Premia: Additional returns that investors require to hold risky alternative investments and can be grouped into four broad categories: Risk Transfer Premium: This premium is generated by taking on risk other market participants wish to avoid and is a form of asymmetric (i.e., one-sided) risk transfer. An example is the return from option writing strategies. This is very similar to the premium earned for providing any form of insurance. In financial markets, it is usually generated by being short volatility. A simple example is writing out of the money put options on any of the liquid asset classes mentioned above. Liquidity Premium: This premium is generated by providing liquidity where needed, usually in markets with high transaction costs or long average investment holding periods. One example is investing in securities of financially distressed firms for which there is a thinly traded market with many motivated sellers and only a few buyers ready to provide the needed liquidity. Spreads: Returns from isolating spreads and investing solely in the spread. Examples of spreads are credit spreads (the return spread between Treasuries and riskier bonds), the return spread between value stocks and growth stocks, or the return spread between small capitalization stocks and large capitalization stocks. Spreads can also be viewed as combinations of asymmetric risk transfer and liquidity premia. Leverage: Finally, hedge funds can apply explicit or implicit leverage to any or all of the sources of return listed above. The use of explicit or accounting based leverage is a form of symmetric risk transfer premium and it increases volatility as well as returns. Implicit or risk-based leverage can be created by either asymmetric or symmetric risk transfer via derivatives. The extent and type of leverage utilized depends on the hedge fund style and varies greatly across different hedge fund styles. However, the use of leverage is a key source of return for many hedge fund strategies.
Individual hedge fund strategies may derive their returns from some, but usually not all, of the potential sources listed. With this framework in mind, we can now delve deeper into hedge fund styles and some of the more prominent strategies within each style. Although we use our own characterization of hedge fund styles (Directional, Relative Value or Event Driven), we closely follow HFRIs description of individual hedge fund strategies in what follows. n Hedge Fund Styles
Hedge funds can be divided into three main styles: Directional, Relative Value, and EventDriven.
Multiple hedge fund strategies can be grouped into hedge fund styles based on similarity in aspects of the decision-making rules governing the investment process within each style.
Exhibit 4: Overview of Hedge Fund Styles
Style Directional Relative Value Investment Process Make combined decisions on market direction and security selection to varying degrees. Underlying Market(s) Currencies, commodities, equities, bonds or derivates of any of these
Usually bonds, equities or their Detect and exploit perceived pricing derivatives discrepancies between similar financial instruments. Buy undervalued instruments and short-sell overvalued instruments. Use substantial leverage to amplify gains from small pricing discrepancies between stable financial instruments such as bonds. Analyze and predict the impact of significant corporate events such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks. Entire spectrum of corporate securities such as bank debt, trade claims, bonds, preferred stock, common stock, options and warrants
Event-Driven
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Assets in the hedge fund universe currently dedicated across the hedge fund styles defined above are displayed in Chart 3. It is important to note that the largest prevalent style is Directional with about 50% of current assets.
Chart 3: 2004 Hedge Fund Universe Composition Percent of Estimated Total Assets Under Management
Event Driven, 20%
Directional, 50%
Relative Value, 30%
Source: HFRI (www.hedgefundresearch.com), Merrill Lynch
We do not treat Managed Futures as part of the Hedge Fund universe because they are typically run by Commodity Trading Advisors (CTAs) and are subject to a somewhat different set of regulations in comparison to hedge funds and thus have different structural features. Managed futures also use somewhat different investment strategies.
Directional hedge funds invest based on a combination of security selection and an assessment of general market direction.
Directional Strategies
Global Macro (Macro): These funds make directional and opportunistic investments in currencies, commodities, equities or bonds on a global basis based on macroeconomic, political and market analysis. Such funds tend to use moderate to high implicit leverage through the use of financial and non-financial futures, swaps and other derivative instruments. Equity Long/ Short (Equity Hedge): These funds combine long and short positions in equities but their resulting portfolio generally has a long bias, although at times some funds do end up being net short. While a number of such funds tend to have a lower correlation with the overall direction of the market, on average such funds do have a directional bias. These types of funds use moderate explicit leverage. Emerging Markets: Funds implementing this strategy are primarily long oriented because many emerging markets do not allow short selling and do not have derivative products. They invest in the stocks, corporate bonds or sovereign debt of emerging markets around the world. They may shift their investment weightings between certain regions, or invest solely in one region. Short Selling (Dedicated short bias): These funds specialize in profiting from short sales of securities, primarily equities and tend to maintain a net short bias in almost all market conditions. Specific stocks are chosen as short sale candidates based on fundamental or technical analysis but the overall portfolio tends to move in the opposite direction of the market.
Relative Value hedge funds typically exploit small price discrepancies between similar financial instruments.
Relative Value Strategies

Fixed Income Arbitrage: This strategy seeks out discrepancies between the prices of almost identical fixed income instruments. When the prices of such instruments diverge too much, these managers usually predict that their prices will converge. Substantial leverage is generally used.
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Convertible Bond Arbitrage: These funds exploit perceived pricing discrepancies between a convertible corporate bond and its component financial instruments i.e., a non-convertible corporate bond and a warrant to convert the bond into equity. A typical trade in this strategy is to buy the convertible bond and dynamically short sell a prescribed amount of the companys stock in order to hedge exposure to the warrant. Such funds may use moderate to high leverage. Equity Market Neutral: This is a quantitative style that invests equal dollar amounts in a long and short portfolio of equities in such a manner that the market exposure of the combined portfolio cancels out. Thus, the overall portfolio derives its returns solely from security selection. Such funds may use low to moderate leverage.
Event-Driven hedge funds invest to profit from corporate events such as M&A, bankruptcies, and the like.
Event-Driven Strategies
Merger Arbitrage: These hedge funds speculate on the consummation of mergers and acquisitions by taking opposite positions in the stocks of the buyer and target companies. Such funds may use low to moderate leverage. Distressed Securities: These funds take positions in the capital structure of companies experiencing financial distress i.e., those either approaching, in or exiting bankruptcy. They identify undervalued securities and sometimes attempt to maximize the value of their investments by actively participating in bankruptcy negotiations. Such funds generally use low leverage. n Funds of Hedge Funds In addition to these strategy-specific hedge fund styles, many investors consider investing in a fund of hedge funds (FoHFs) in order to gain diversified exposure to hedge funds in their portfolios. FoHFs invest in multiple hedge funds and are set up as privately held entities (LPs or LLCs). The FoHF manager chooses hedge fund styles and strategies to invest in and creates a portfolio of hedge funds, thereby significantly lowering the risks of investing only with individual managers. An FoHF manager may allocate funds to numerous managers within a single strategy, or to numerous managers in multiple strategies. Some FoHFs first develop views on a hedge fund strategy and then select individual managers within the strategy. FoHFs offer investors at least two advantages relative to direct investments in hedge funds:
FOHFs offer the benefits of diversification, ongoing assessment and risk management by experienced professionals, but this comes at the cost of an additional layer of fees.
1.
Diversified exposure to hedge funds with lower minimum investment amounts which is helpful for smaller portfolios. Many individual hedge funds have high minimum investment amounts, typically $500,000. Our belief is that some diversification within hedge funds is essential for a long term allocation to hedge funds within an investors portfolio. However, diversified exposure to individual hedge funds requires a very large portfolio in order to meet the minimum investment criterion. For example, in order to have a 5% portfolio allocation to hedge funds with exposure to 5 different hedge funds, an investor would need to have a portfolio worth $50 million. More diversified exposure would require an even larger portfolio. Expertise in the selection and monitoring of hedge fund strategies and managers to investors new to hedge funds, or to those not large enough to run their own hedge fund portfolios. The cost of this expertise is spread over all the FoHF investors. Since hedge funds are lightly regulated, finding information about hedge fund managers and evaluating them along multiple criteria is a time consuming process that also requires manager evaluation expertise. FoHFs have dedicated teams of analysts to select and monitor hedge fund strategies and managers. These professionals typically have well developed networks and specific expertise within this relatively reticent investment community. They conduct extensive due diligence on managers and funds under consideration and then assess their quality with respect to a variety of risks such as market, credit, liquidity, funding, operational, regulatory and reputational risks. FoHFs also have dedicated portfolio managers and risk managers to construct and monitor portfolios of hedge funds.
2.
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These advantages come at the cost of an additional layer of fees. Generally, FoHFs liquidity terms are similar to those of the underlying funds they invest in. Choosing to invest via FoHFs requires a cost-benefit and risk analysis. Keep in mind that all hedge fund data is presented net of hedge fund management and performance fees. The data for FoHFs represents returns after the management and performance fees of both the FoHFs and the underlying hedge funds have already been deducted. We will analyze fund of hedge funds using HFRIs Fund of Funds Composite index. This is an equally weighted average of those funds of hedge funds that report returns to the HFRI database. n Historical Performance of Hedge Fund Strategies
We analyze the performance history of 13 different Buy & Hold strategies over our historical horizon using HFRI and other data: 1. Directional Strategies a. Macro b. Equity Hedge c. Emerging Markets d. Short Selling 2. Relative Strategies a. Fixed Income Arbitrage b. Convertible Bond Arbitrage c. Equity Market Neutral 3. Event Driven Strategies a. Merger Arbitrage b. Distressed Securities 4. Fund-of-funds Composite Index (an equal weighted index of FoHF returns) 5. Fund Weighted Composite Index (an equal weighted index of hedge fund returns) 6. S&P 500 Index 7. Merrill Lynch US Domestic Master Fixed Income Index
We start our analysis of monthly returns from January 1994, when the HFRI indices were introduced. The data in the HFRI database goes back to January 1990, but HFRI backfilled the returns between January 1990 and December 1993, and this part of the data may be prone to survivorship bias. Therefore, we have chosen to use the data from January 1994 to April 2005, (henceforth, historical horizon). In the Appendix, we repeat our analysis using the CSFB/Tremont family of hedge fund indices over the same time horizon. Note that the approximately 11 years of data being used to assess historical performance is a short time frame in comparison to data for equities and fixed income securities. With so many returns series being examined, a natural question is, What best represents composite hedge fund performance? There are two important issues investors should understand before we answer this question. 1. Hedge fund strategies are very heterogeneous: They had widely differing returns, risks and correlations in our historical horizon. Examining all hedge funds together in a composite manner may obscure this heterogeneity, which is an important source of diversification. Hedge fund composites are generally not investable: All hedge fund indices are either equally weighted or asset value weighted averages of returns from individual hedge funds belonging to the index. It is very difficult to fully replicate such an index. The only way to do so would be to hold a portfolio of all managers in the index, which is quite difficult in practice. Even the investable versions of hedge fund indices invest in a small subset of the managers in the index and their returns can deviate substantially from those of the calculated full index. This is in contrast to traditional indexes such as the S&P 500 which can be replicated very closely by many liquid investment products.
2.
With these limitations in mind, we still have the practical issue of which single index best represents the composite performance of hedge funds. In our opinion, of the indices we have considered, for many individual investors an index of FoHFs such as the HFRI Fund of Fund Composite is the most representative single index of returns from hedge funds from a practical point of view for two reasons: 1. Lower selection bias: The Fund of Funds Composite performance history is less affected by database selection bias. It includes the performance of some funds that do not report to the database. Internally diversified: The Fund of Funds Composite performance comes closest to being that of a diversified portfolio of hedge funds. This makes it comparable along this dimension to an internally diversified index such as the S&P 500 which is exposed to several sectors and industries of the economy.
2.
Before we evaluate the historical performance of hedge funds, we would like to lay out the steps of our analysis for those who might be unfamiliar with some of the concepts, or thought process, normally used to evaluate asset performance: Since investors prefer higher returns to lower returns, we start our analysis by looking at historical returns.
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Evaluating the historical performance of assets requires information about prior returns, a quantitative assessment of the risk taken to achieve those returns, and how correlated the investments return is to the other components of a portfolio.
Higher returns are generally associated with higher risk in well functioning markets. Therefore, we need to look at risk as well as returns. For a given level of return, investors prefer lower levels of risk. In the main section of the report, we first use volatility (standard deviation of returns) as our measure of risk. We then adjust volatility to correct for short term trends (serial correlation) in the data. The Appendix uses another measure of risk that is free of any adjustment for serial correlation and better captures the notion of risk as the potential for loss below a pre-specified hurdle rate. We generally find a variety of risk-reward tradeoffs for any given set of investment alternatives. In such a situation, the ratio of returns in excess of cash equivalents to risk can be a good way of comparing the risk adjusted returns of different investment alternatives, in our case hedge funds. This ratio is known as the Sharpe ratio. In choosing a single investment from a set of alternatives, investors prefer those with higher values of the Sharpe ratio. An investors situation is often characterized by the decision to choose an incremental investment given an existing portfolio which is commonly a mix of stocks and bonds. In choosing an incremental investment amongst those with similar Sharpe ratios, investors prefer investments which are different from the existing portfolio. This difference is measured by correlation with the existing portfolio. In general, all else being equal, lower correlation investment alternatives are preferred.
Table 1: Annualized Return Characteristics

Strategy Over full period examined* 1/94 - 4/05 14.17% 12.30% 11.34% 10.31% 10.10% 9.80% 9.55% 9.40% 8.05% 7.19% 6.62% 5.98% 1.31% Compound Annualized Return Over high negative return Over high positive return period in Stocks period in Stocks 1/00 - 12/02 1/97 - 12/99 1.44% 27.33% 7.02% 8.92% 2.68% 16.31% -14.55% 27.56% 5.39% 14.07% 6.33% 12.60% 0.72% 6.79% 12.29% 12.01% 7.27% 9.63% 2.62% 11.72% 10.14% 5.74% 6.10% 1.02% 23.75% -7.91%
HFRI - Equity Hedge HFRI - Distressed Securities HFRI - Fund Weighted Composite S&P 500 Index HFRI - Macro HFRI - Merger Arbitrage HFRI - Emerging Markets HFRI - Convertible Arbitrage HFRI - Equity Market Neutral HFRI - Fund of Funds - Composite ML Domestic Master F.I. Index HFRI - Fixed Income - Arbitrage HFRI - Short Selling
Over last 5 years 5/00 - 4/05 4.34% 13.05% 5.99% -2.94% 8.48% 4.77% 11.45% 6.67% 5.14% 4.42% 7.52% 7.15% 8.96%
Source: Bloomberg, Merrill Lynch, HFRI Table Note: Compounded annual rates of return correspond to returns from a buy and hold investment in each strategy without rebalancing. * - Entire table sorted in descending order by this column
n Hedge Funds Generated a Wide Variety of Returns The compounded annual rates of return delivered by the various hedge fund strategies over our historical horizon as well as three smaller periods within this full horizon are shown in Table 1. For comparative purposes, we have also shown gross returns delivered by Stocks, as represented by the S&P 500 index, and Bonds, as represented by the Merrill Lynch US Domestic Master Fixed Income Index over the same time periods. Since returns on Stocks and Bonds are gross, i.e., before the effect of fees, any comparisons we make are conservative since after-fee or net returns on Stocks and Bonds would be lower. Each column of returns represents the annualized rate of return an investor would have earned from equal dollar amounts invested in each strategy at the beginning of the relevant period and held through till the end of such period.
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Hedge fund strategies and FoHFs had a wide range of returns versus stocks and bonds.
A key point to note is that there was a wide range of return outcomes and several hedge fund strategies that performed better, as well as others that performed worse, than both Stocks and Bonds over all time horizons. These historical returns show that there is a tremendous amount of variety within hedge fund strategies and investors need to be careful not to treat the hedge fund universe as homogenous. Additionally, in the Appendix section Persistence amongst strategies, we show that there is tremendous variation in the set of strategies that did well in any particular year. Since business conditions and market opportunities vary by year, superior hedge fund strategy selection has the potential to add considerable value. The returns data in this table are consistent with our conceptual framework (Exhibit 3) outlining the potential for significant variety in the sources of hedge fund returns. Just as there are sectors in the stock market that have different return characteristics over different time frames, so too there are hedge fund strategies that have different sources of return within the hedge fund universe. A second point to note is the performance of hedge funds during different regimes of returns in Stocks. The second column of returns in Table 1 outlines strategy returns during a period of low equity returns the three years beginning January 2000. All hedge fund strategies outperformed Stocks over this period and a few outperformed Bonds as well. The data in this column shows that hedge fund strategies performed quite well during the most recent prolonged episode of negative returns in Stocks i.e., hedge fund strategies did hedge equity market exposure during this period. This finding is consistent with our earlier argument that hedge funds have greater protection from bear markets because of the lack of explicit benchmarking. The third column of returns in Table 1 outlines strategy returns during a period of high equity returns the three years beginning January 1997. Most hedge fund strategies underperformed Stocks over this period but most did deliver positive returns and most of them outperformed Bonds. Additionally, the last column of returns in Table 1 shows returns over the last five years ending March 2005. Again many hedge fund strategies outperformed both Stocks and Bonds over this period. Another important observation from Table 1 is the difference in returns between that of the Fund Weighted Composite index (11.34%) and the Fund of Funds Composite index (7.19%). The 4.15% difference between these two indices reflects the effect of additional fees, the specific manager selection decisions of FoHF managers and the lower risk taken by FoHF managers (shown in Tables 2 and 3). Despite this lower return, we maintain our earlier opinion that of the indices we have considered, from a practical point of view an index of FoHFs such as the Fund of Fund Composite is the most representative single index of returns from hedge funds for many individual investors. Table 1 does not say anything about the risk of these strategies. We examine this next. n Hedge funds took on a wide variety of risks
Table 2 shows the wide variation in standard deviation (volatility of returns) but interestingly most types of hedge fund exhibited lower volatility than Stocks and many were even lower than Bonds.
Table 2 shows the annualized standard deviation of monthly returns (also known as volatility) by strategy in addition to compound annual returns of each strategy. Standard deviation, or volatility, is a measure of the dispersion of returns around their average and is the standard statistical measurement of risk. The strategies are sorted in ascending order of volatility in Table 2. For any two otherwise equivalent investments, investors would normally prefer the one with a lower standard deviation.
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Table 2: Annualized Volatility Characteristics (1/94 4/05)

Strategy HFRI - Equity Market Neutral HFRI - Merger Arbitrage HFRI - Convertible Arbitrage ML Domestic Master F.I. Index HFRI - Fixed Income - Arbitrage HFRI - Distressed Securities HFRI - Fund of Funds - Composite HFRI - Fund Weighted Composite HFRI - Macro HFRI - Equity Hedge HFRI - Emerging Markets S&P 500 Index HFRI - Short Selling Unadjusted Historical Standard Deviation (Volatility)* 3.18% 3.65% 3.74% 3.95% 3.97% 5.53% 5.91% 7.19% 7.42% 9.15% 14.73% 15.10% 21.98% Compound Annual Return 8.05% 9.80% 9.40% 6.62% 5.98% 12.30% 7.19% 11.34% 10.10% 14.17% 9.55% 10.31% 1.31%
Source: Bloomberg, Merrill Lynch, HFRI * - Entire table sorted in ascending order by this column
Just as we saw a large variation in returns among the different styles and types of hedge funds, we also observe a large variation in volatility across hedge fund strategies over this time horizon. Interestingly however, all strategies except Short Selling were less volatile than Stocks, and many were less volatile than Bonds. While this may indicate a lower volatility profile for hedge fund strategies, we need to further our analysis before we reach such a conclusion. A statistical phenomenon that occurs in hedge fund returns data, and distorts the measurement of the volatility, is known as serial correlation. This is the tendency of a return series to either be trend persistent or trend reverting over short horizons. By trend persistent we mean that the return of a strategy in a given month is positively correlated with its own returns in previous months, i.e., positive returns are likely to follow positive returns in the short term and likewise for negative returns. Similarly, by trend reverting we mean that the return of a strategy in a given month is negatively correlated with its own returns in previous months, i.e., positive returns are likely to follow negative returns in the short term and vice versa. Zero serial correlation indicates no linear association between returns of a strategy in a given month and its returns in previous months; it also means that the return series is trend-free or random in the short term.
The presence of positive serial correlation or trend persistence in hedge fund return data causes an understatement of the volatility over long time horizons. We need to correct for this to get more meaningful comparisons.
The presence of serial correlation in returns distorts the measurement of volatility over long horizons. Volatility over long horizons is understated in the presence of positive serial correlation because persistent short term trends in the returns will result in a high variation of such returns relative to variation in trend free random returns. Similarly, volatility over long horizons is overstated in the presence of negative serial correlation because trend reversion in short term returns will result in a low variation of such returns relative to variation in trend free random returns. Therefore, long run volatility is accurately measured by standard deviation only in the presence of zero serial correlation in all other cases certain statistical adjustments are required to extrapolate long run volatility from the standard deviation observed over a sample time horizon.
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Table 3: Effect of Serial Correlation on Annualized Volatility (1/94 4/05)
We calculate the long run volatility to adjust for serial correlation. Note that volatility is increased for most hedge fund strategies after the correction.
Strategy HFRI - Equity Market Neutral HFRI - Merger Arbitrage HFRI - Convertible Arbitrage ML Domestic Master F.I. Index HFRI - Fixed Income - Arbitrage HFRI - Distressed Securities HFRI - Fund of Funds - Composite HFRI - Fund Weighted Composite HFRI - Macro HFRI - Equity Hedge HFRI - Emerging Markets S&P 500 Index HFRI - Short Selling
^Unadjusted ^^Adjusted Long Historical Standard Run Standard Deviation (Volatility)* Deviation (Volatility) 3.18% 3.30% 3.65% 4.23% 3.74% 4.28% 3.95% 3.86% 3.97% 4.81% 5.53% 6.89% 5.91% 7.03% 7.19% 8.34% 7.42% 7.19% 9.15% 10.46% 14.73% 17.45% 15.10% 15.96% 21.98% 23.48%
Percent Change in Volatility due to Serial Correlation 4% 16% 14% -2% 21% 25% 19% 16% -3% 14% 18% 6% 7%
Source: Bloomberg, Merrill Lynch, HFRI ^ - Volatility of the strategies as measured by the annualized standard deviation of returns over the historical horizon (1/94 to 4/05). ^^ - Our estimate of volatility adjusted for the effects of serial correlation. * - Entire table sorted in ascending order by this column
There are at least three ways to adjust volatility for the presence of serial correlation and we discuss these methods briefly in the Appendix section Adjusting for Serial Correlation. In general, all such procedures aim to incorporate the impact of shortterm trends in prior returns by adjusting volatility estimates upwards or downwards. 5 As mentioned in the Appendix, we adjust volatility using the Newey-West procedure. The net impact of serial correlation on the volatility estimate for the S&P 500 is minor (Table 3) it results in only a 6% increase in volatility due to the negligible serial correlation in S&P 500 returns. The volatility of Bonds also requires a small downward adjustment due to the trend reverting nature of interest rates. However, the volatility in hedge funds undergoes more pronounced adjustments. For example, Distressed Debt has an Unadjusted Historical volatility of 5.53%, but an Adjusted Long Run volatility of 6.89%, a 25% increase in volatility. While this strategy had the most severe adjustment, most other strategies have material upward revisions to volatility as well. Comparing the middle two columns of Table 3, we find that most hedge fund returns become more volatile than those of Bonds. Investors may wonder what causes serial correlation in hedge fund returns. After all, hedge funds deploy investment strategies in the traditional asset classes of stocks and bonds, so why should their returns have trends? Although a definitive answer is difficult, we believe there are two possible reasons. For some hedge funds, positive serial correlation is induced by illiquid positions carried in the portfolio. An illiquid position, by definition, is not actively traded and thus there may not be any readily available quotes for such a security when it is marked to market periodically. In order to mark these securities to market prices at month-end, hedge fund managers, and even the sources they get third party quotes from, may have to rely on a subjective assessment (i.e., an appraisal) of the value of such a security as opposed to a marketable price. These assessments rely on fundamental or quantitative techniques and do not vary as much as actual traded prices do. This problem is especially acute in Distressed Debt trading where defaulted bonds may go weeks without a trade. In that case, there may be a tendency to mark such bonds at the last known trading price which is both generally stale and not subject to much movement over time.
5
Newey, Whitney K. and Kenneth D. West, "A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix", Econometrica, May 1987.
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In the absence of illiquid positions, another possible reason for serial correlation is potentially strong active management skill. A manager who produces a steady stream of mostly positive returns is likely to display highly positive serial correlation. Effectively, such a manager would use superior skill to transform raw asset returns into a steady stream of positive active returns. The serial correlation pattern of such a highly skilled manager could potentially resemble that of Treasury Bills an investment with very high levels of serial correlation in its return profile. However, given that there can be two rather different reasons for serial correlation, further statistical analysis of the managers returns and fundamental analysis of the managers investment strategy would be required before either hypothesis about the cause of serial correlation could be confirmed. Conducting such an analysis requires manager level data that we do not analyze in this report. n The Historical Risk-reward Tradeoff in Hedge Funds Was
Favorable
Having accounted for the effects of serial correlation, we are now in a better position to assess the risk (volatility) adjusted returns in hedge funds. The Sharpe ratio is a widely used tool to calculate the reward for bearing volatility. The historical or realized Sharpe ratio is defined as the ratio of the average returns in excess of cash divided by the volatility of returns over the historical horizon. We use the returns on 30 day Treasury Bills as our proxy for cash, which averaged 3.85% annualized over our time frame. Higher values of the Sharpe ratio indicate a higher return for bearing each unit of volatility and are considered better than lower values. For a given average excess return, the lower the volatility, the higher is the Sharpe ratio.
Table 4: Annualized Sharpe Ratios (1/94 4/05)
Sharpe ratios, which calculate the reward for bearing volatility (or risk), must also be adjusted for serial correlation as is done in Table 4. Higher Sharpe ratios are preferred to lower ones. Even after adjustment, most hedge fund strategies had higher Sharpe ratios than Stocks or Bonds.
Strategy HFRI - Merger Arbitrage HFRI - Convertible Arbitrage HFRI - Equity Market Neutral HFRI - Distressed Securities HFRI - Equity Hedge HFRI - Fund Weighted Composite HFRI - Macro ML Domestic Master F.I. Index HFRI - Fund of Funds - Composite S&P 500 Index HFRI - Fixed Income - Arbitrage HFRI - Emerging Markets HFRI - Short Selling
Unadjusted Historical Sharpe ratio 1.55 1.42 1.27 1.45 1.09 1.01 0.83 0.69 0.57 0.48 0.53 0.44 0.00
Adjusted Long Run Sharpe ratio* 1.34 1.24 1.22 1.16 0.95 0.87 0.86 0.70 0.48 0.45 0.44 0.37 0.00
Percent Change in Sharpe ratio due to Serial Correlation -14% -13% -4% -20% -13% -14% 3% 2% -16% -5% -18% -16% -6%
*- Entire table sorted in descending order by this column Table Notes: - The second column shows the Sample Sharpe Ratio which uses the sample standard deviation, i.e., unadjusted volatility over the entire period examined. - The third column shows the Adjusted Long Run Sharpe Ratio which uses Adjusted Long Run volatility - The last column shows the percent change in the two types of Sharpe ratios for each strategy because of the adjustment to volatility. Source: Bloomberg, Merrill Lynch
The serial correlation adjustment makes a material difference to hedge fund returns and in general lowers the risk reward tradeoff for these strategies. However, the key point is that even after adjusting Sharpe ratios for the effects of serial correlation, most hedge fund strategies still had higher Sharpe ratios than either Stocks or Bonds.
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We examine the risk-reward tradeoff in further technical detail in the Appendix to account for the different nature of risks found in hedge funds. Using a relatively new measure of downside risk to reward tradeoff, we still find that for most investors, several hedge funds strategies would have delivered a superior tradeoff in the historical period we examine. n Hedge Funds Had Moderate to Low Correlation with Traditional
Assets We look at correlation to see how hedge funds perform in conjunction with traditional assets in a portfolio.
We have now looked at average returns and measures of risk. However, we still need to examine how hedge funds perform in conjunction with the assets in a traditional portfolio. Hedge funds tend to have low correlation with traditional asset classes such as Stocks and Bonds. Correlation is a measure of the association between any two series of returns. Correlation always lies between -1.0 and +1.0. A correlation of +1.0 between any two series of returns means that the two return series move perfectly in tandem. However, a correlation of -1.0 signifies that the two return series always move in opposite directions. A correlation of zero implies that the two series have no linear association with each other. From an asset allocation perspective, for given levels of return and volatility, investors should prefer investments that have low or negative correlation with each other. If investors had a choice between new investments with equal average returns and equal risks (i.e., equivalent Sharpe ratios), then they should prefer the investment with the lowest correlation to their existing portfolio. Such a combination would increase the chance that when part of the portfolio disappoints, other parts of the portfolio have the potential for positive surprises, thereby smoothing out the total returns from the portfolio. Adjusted Long Run correlation (Table 5) is the estimate we obtain after adjusting the data for the effects of serial correlation in each pair of returns of hedge fund strategies with Stocks and Bonds. Recall that we are using the Newey-West procedure to make this adjustment. In our opinion, Adjusted Long Run correlation is a better measure of association between two return series than the usual estimate of sample correlation. The usual estimate of correlation, which we call the Unadjusted Historical correlation, only measures contemporaneous association and does not adjust for serial correlation. Unadjusted Historical correlation is shown in the Appendix.
Table 5 shows that hedge fund strategies showed moderate to low correlation with Stocks and Bonds in the period examined.
Table 5: Correlation Analysis (1/94 4/05)

Strategy S&P 500 Index HFRI - Fund Weighted Composite HFRI - Equity Hedge HFRI - Merger Arbitrage HFRI - Emerging Markets HFRI - Fund of Funds - Composite HFRI - Distressed Securities HFRI - Macro HFRI - Convertible Arbitrage HFRI - Equity Market Neutral HFRI - Fixed Income - Arbitrage ML Domestic Master F.I. Index HFRI - Short Selling
Source: Bloomberg, Merrill Lynch, HFRI * - Entire table sorted in descending order by this column
Adjusted Long Run Correlation Stocks* Bonds 1.00 -0.18 0.72 -0.22 0.71 -0.21 0.62 -0.14 0.54 -0.27 0.50 -0.16 0.44 -0.20 0.34 0.14 0.30 0.03 0.15 0.19 -0.11 -0.10 -0.18 1.00 -0.71 0.24
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To put the data in Table 5 in perspective, consider the Adjusted Long Run correlation between Stocks and Bonds (-0.18). This negative correlation implies that a portfolio invested in a mix of Stocks and Bonds over this historical period would have resulted in a more diversified portfolio with positive returns from Bonds offsetting contemporaneous negative returns from Stocks and vice versa. The Adjusted Long Run Correlation of individual hedge fund strategies with Stocks ranged from 0.71 for Equity Hedge to -0.71 for Short Selling. For Bonds, the range was from 0.24 for Short Selling to -0.27 for Emerging Markets. Table 5 provides the insight that the performance of hedge fund strategies can be quite different from that of traditional assets. Hedge funds thus expand the investment opportunity set for investors in a meaningful way and do not merely replicate returns from traditional assets. Many, but not all, hedge fund strategies have low and even negative correlation with Stocks and Bonds. Combined with their positive historical returns, including such low correlation hedge funds would have effectively diversified risks in a portfolio of Stocks and Bonds and would have resulted in better portfolios over the time frame examined.
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5. What Weve Learned

Hedge funds, which are lightly regulated investment structures with a wide variety of investment strategies, have been rapidly attracting assets over the past fifteen years. Additionally, fund of hedge fund (FoHF) structures have allowed more investors access to this type of asset management. Such structures add a key benefit of diversification at the cost of additional fees. Investors should understand that hedge funds, even funds of hedge funds, are highly heterogeneous. Exact analogues of averages or composites of traditional asset classes, such as the S&P 500, are unavailable in the hedge fund universe due to voluntary reporting, lower liquidity, and other factors that differentiate hedge funds from, say, mutual funds or an investors personal portfolio of liquid stocks and bonds. We have described the many styles of hedge funds, as well as the characteristics that allow us to assess overall performance: historical returns, volatility, riskadjusted returns (the Sharpe ratio) and correlation. We have adjusted many of the above to account for positive serial correlation and other technical factors that are discussed in the Appendix. What we have learned is that in the period examined, January 1994-April 2005, even after we make numerous technical adjustments that adversely affect hedge fund performance, many hedge fund strategies would still have provided investors with higher returns than stocks and bonds, with lower risk, and with some benefits from limited correlation with stocks and bonds. Over a prolonged period of negative returns in stocks, viz. January 2000 December 2002, most hedge fund strategies did outperform stocks.
Some caveats:
As this is a historical analysis in the spirit of a primer, investors cannot draw any conclusion from this report about whether to add hedge funds to their portfolio, or which hedge fund strategies would perform best. Forward-looking expected returns require different analysis than historical analysis of known data. Additionally, we have analyzed only one strategy at a time and have not examined combinations or portfolios of strategies relative to each other. Investors can always achieve higher Sharpe ratios or other portfolio performance measures with diversification across strategies and asset classes. However, constructing such portfolios is an exercise in asset allocation and again, in the spirit of writing a primer describing hedge funds, is not within the scope of this report. We plan to address this issue in a separate report. Lastly, returns from individual hedge funds or funds of hedge funds would have been likely to exhibit different patterns of returns from our analysis, which is based on indices and assumes that the initial investment was made in January 1994 and held until April 2005. In reality, investors would have had to invest in specific hedge funds with potentially very different returns from the indices we analyzed.
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6. Appendix
n Defining an Investment Strategy An investment strategy can be defined as a choice of allocations to investment choices over time. The simplest investment strategy is a buy and hold (B&H) strategy. In such a strategy, an investor purchases the investment and holds it over the entire investment horizon. For example, an investor may purchase a certain amount of the S&P 500 index and hold on to it indefinitely. This is a passive or static investment strategy because a decision is made only once at the beginning of the investment horizon. A dynamic investment strategy is one in which the decisions are made at many points over the investment horizon. A common dynamic investment strategy is the constant proportions (CP) strategy. In such a strategy, an investor periodically rebalances a portfolio to a fixed mix of investments. For example, an investor may start with a 60% allocation to Stocks and a 40% allocation to Bonds and then rebalance the portfolio annually to these proportions. In a constant proportions (CP) strategy, the decision rule to be implemented (e.g., the 60/40 mix above) is specified in advance and does not change over the investment horizon. Rules of other dynamic investing strategies are more complicated. These rules may be developed systematically before investing begins and may evolve during the investment horizon. Alternatively, decision rules may be based primarily on the subjective judgment of the decision-makers. In either case, we call such complex and dynamic investment strategies active investment strategies. Traditional active strategies are those active strategies which are explicitly benchmarked to an index or combination of broad market indices in traditional asset classes (i.e., stocks and bonds). An example would be the investment strategy followed by an open end actively managed mutual fund that is benchmarked to the S&P 500 index. n The Implications of Portfolio Management Flexibility Flexibility in portfolio management expands the opportunity set for hedge fund managers because it enables them to cast a wider net in search of profitable investment opportunities. As a result, hedge funds take on much more active risk as compared to more regulated investment managers. To better understand the value of the portfolio management flexibility that hedge fund managers have, consider two hypothetical portfolio managers H and M within a defined universe of securities (say US MidCap stocks). Let us assume that H and M have identical skill in security analysis and selection. Further, let us also assume that they have identical analytical processes and sources of information. Both are tasked to manage $100 million in net assets using active security selection. The only difference between the two is that H operates an equity long-short hedge fund and M operates a traditional actively managed open-end mutual fund. To make the example more realistic, let us assume that M is explicitly benchmarked to an appropriate index, such as the S&P Mid Cap Index, whereas H is not explicitly benchmarked at all. Relative to M, H has the following advantages: 1. Unrestricted short selling: It is entirely plausible that as H and M analyze the same set of securities, they will come up with negative views on some of them. Further, given our assumptions, they would be equally negative on an identical set of securities. The only difference in their performance would stem from the restrictions they face in security selection and portfolio construction which we outline below: H faces very few regulatory restrictions in shorting stocks but M is severely constrained from doing so. Moreover, most mutual funds generally take only long positions in stocks. Thus, given these equally negative views on the same set of stocks H is allowed to express these views freely by shorting the stocks whereas M is severely constrained from doing so.
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Additionally, relative to H, regulations governing M impose a higher cost of financing a short position. Current regulations would prohibit M from shorting stocks unless M segregates enough liquid assets to cover the short position. Segregating liquid assets has an opportunity cost M would have to keep the full amount of the short position in cash equivalents and these funds would not be available to invest in any other securities where expected returns are higher. On the other hand, H can short stocks by posting existing portfolio holdings as collateral and will typically receive some revenue in the form of a short rebate on the proceeds received from shorting. Effectively, this makes shorting a much more costly process for M than for H. Thus, given equally negative views on particular stocks which will come up from time to time, H has more opportunity to express these views in the portfolio with a built-in cost advantage relative to M. Therefore, in our view, H has a competitive advantage relative to M and hence, the potential to deliver higher returns from active investing.
2.
Unrestricted use of illiquid securities: It is also entirely plausible that on a few occasions, both H and M may identify undervalued but illiquid securities. Investors should reasonably expect a liquidity premium or extra return from illiquid securities compared to otherwise similar but liquid securities. This is because illiquid securities force either a longer holding period or higher transaction costs on the holder. Since investors are aware of this dynamic before making the decision to transact, in general they will not transact unless they expect to be compensated for this illiquidity in the form of higher average returns over and above those available from otherwise similar but liquid securities. However, per current regulations, M cannot hold more than 15% of net assets in illiquid securities whereas H has no restriction whatsoever. As H and M individually analyze lower capitalization stocks in their universe, they are likely to find a higher proportion of attractive yet illiquid stocks. At some point, the 15% limit may become binding on M while H could still add these attractive yet illiquid stocks to the hedge fund portfolio. Again, even with equal skill, this is a competitive advantage for H. Greater protection in bear markets: Suppose H and M both forecast a bear market, i.e., high negative returns, for their identical universe of US MidCap Stocks. If M is explicitly benchmarked, M needs to maintain significant market exposure to the benchmark despite forecasting negative returns. H however can create a long-short portfolio that has no significant exposure to the benchmark and benefits only if the longs outperform and shorts underperform. H could also create a negative exposure to the benchmark, thereby benefiting if the bear market forecast comes to pass. Thus H again has a competitive advantage relative to M, this time due to the flexibility of not being explicitly benchmarked. The lack of an explicit benchmark is an important feature of hedge fund strategies. When combined with the investment mandate flexibility afforded to hedge funds, it implies that hedge funds have a greater ability to protect themselves from generating negative returns, compared to explicitly benchmarked investment strategies.
3.
Thus, given equal skill in security selection, H thus has a better chance than M of realizing higher returns from security selection. It is also important to recognize that this advantage stems from the structure or legal entity in which the investing takes place. We already assumed that both H and M had equal skill and in our stylized example above the only reason for different returns between them is attributable to the different rules under which they are allowed to express their security selection views.
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n Addressing Serial Correlation There are at least 3 ways to adjust volatility estimates for the presence of serial correlation. In general, all such procedures aim to incorporate the impact of trends in prior returns by adjusting volatility estimates upwards or downwards. Before going into the pros and cons of these approaches, we first emphasize that each of these methods tries to approximate a statistical quantity called volatility. Effectively, the methods can be better or worse approximations depending on the context in which they are used. For the technically inclined, the 3 methods commonly used to correct volatility estimates for the presence of serial correlation are: 1. Summed Beta approach: Fitting a distributed lag regression model to the time series of returns and summing up the betas to proxy contemporaneous beta. Volatility is then estimated by solving for it in the standard expression for contemporaneous beta. Unsmoothing approach: Transforming raw or smoothed returns into unsmoothed returns so that average returns remain the same but volatility reflects the lag 1 autocorrelation. Newey-West approach: Estimating a heteroskedasticity and autocorrelation consistent (HAC) estimate of the covariance matrix of the multivariate time series of returns.
2.
3.
Without going deeper into technical details, we decided to use the Newey-West approach because it simultaneously corrects volatility and cross correlation for the effects of serial correlation at multiple lags in a mathematically consistent manner. The other two approaches do not share this advantage. Readers should note that somewhat different estimates of volatility are obtained by using each of the three techniques and this may alter the volatility rankings of the different strategies depending on the method used. In our opinion, the Newey-West approach is the most appropriate procedure for the task at hand. Table A.1 shows the serial correlation of monthly returns by strategy at 4 monthly lags. We calculated the serial correlation at a given lag, for example lag 2, by computing the correlation between the returns in a given month and returns from the same strategy 2 months prior on a rolling basis. Table A.1 shows that most hedge fund strategies have returns that are trend persistent, i.e., they have positive serial correlation. Table A.1 also shows why serial correlation matters in hedge fund returns and may not matter much in returns from Stocks. This is because the S&P 500 return series have almost zero serial correlation at all lags, thereby indicating almost trend-free returns. Bonds, on the other hand, do display some serial correlation. The p-values from the Ljung-Box test of statistical significance for the null hypothesis of no serial correlation at 1 lag are also shown in the last column. While some strategies do not have serial correlation at the usual significance of 5%, we use the Newey-West procedure to correct for serial correlation in all series to be consistent across series. The Newey-West procedure will only make small adjustments to the estimators of those series that do not have statistically significant serial correlation.
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Table A.1: Serial Correlation in Returns (1/94 4/05)

Strategy* Lag 1 0.53 0.42 0.32 0.20 0.08 0.35 0.34 0.23 0.13 0.23 0.10 0.15 0.00 Serial Correlation Value Lag 2 0.26 0.12 0.06 0.08 0.11 0.03 0.11 0.03 -0.02 0.18 -0.11 -0.11 -0.03 Lag 3 0.07 0.01 0.03 0.06 0.13 0.12 0.00 -0.04 -0.02 0.20 -0.04 0.10 0.07 Lag 4 0.03 0.04 0.00 -0.03 0.14 0.02 -0.08 -0.06 -0.06 -0.01 -0.09 -0.02 -0.07 Statistical Significance Ljung-Box p-value Serial Correlation at at 1 lag 5% significance 0.0000 Significant 0.0000 Significant 0.0015 Significant 0.0540 Insignificant 0.7798 Insignificant 0.0000 Significant 0.0008 Significant 0.0307 Significant 0.8206 Insignificant 0.0089 Significant 0.3472 Insignificant 0.5250 Insignificant 0.9442 Insignificant
HFRI - Convertible Arbitrage HFRI - Distressed Securities HFRI - Emerging Markets HFRI - Equity Hedge HFRI - Equity Market Neutral HFRI - Fixed Income - Arbitrage HFRI - Fund of Funds - Composite HFRI - Fund Weighted Composite HFRI - Macro HFRI - Merger Arbitrage HFRI - Short Selling ML Domestic Master F.I. Index S&P 500 Index
Source: Bloomberg, Merrill Lynch
* - Entire table sorted in alphabetical order by this column
The strategies in Table A.1 are sorted in ascending order of Adjusted Long Run volatility, which is shown in Table 3 in the main section of this report. Serial correlation occurring individually in two different time series also has an effect on their cross correlation with each other. The standard way of estimating correlation takes into account only the contemporaneous association between two series of returns. It does not incorporate the effect of serial correlation in the individual series. We call this standard estimate the Unadjusted Historical correlation. However, we can incorporate the effect of serial correlation in the individual time series in calculating their longer run cross correlation with each other using the Newey-West procedure. We call this the Adjusted Long Run correlation between the series. Both types of correlation of the different strategies with Stocks and Bonds are displayed in Table A.2. What we observe in Table A.2 is that the correlation estimate with respect to Stocks changes only slightly between the Unadjusted Historical and Adjusted Long Run estimates. This is because of the negligible serial correlation in Stocks returns series we pointed out earlier. However, there are material changes between the Unadjusted Historical and Adjusted Long Run estimates of correlation of almost all series with Bonds. This is because Bonds do have some meaningful serial correlation, as shown in Table A.1. Readers should note that we discuss the Adjusted Long Run correlation further in the main section of this report.
Table A.2: Correlation Analysis (1/94 4/05)
Strategy S&P 500 Index HFRI - Fund Weighted Composite HFRI - Equity Hedge HFRI - Merger Arbitrage HFRI - Emerging Markets HFRI - Fund of Funds - Composite HFRI - Distressed Securities HFRI - Macro HFRI - Convertible Arbitrage HFRI - Equity Market Neutral HFRI - Fixed Income - Arbitrage ML Domestic Master F.I. Index HFRI - Short Selling Unadjusted Historical Stocks Bonds 1.00 0.02 0.72 0.00 0.69 -0.01 0.51 -0.02 0.58 -0.07 0.53 0.07 0.47 0.00 0.39 0.32 0.30 0.18 0.15 0.21 -0.12 -0.08 0.02 1.00 -0.69 0.05 Adjusted Long Run Stocks* Bonds 1.00 -0.18 0.72 -0.22 0.71 -0.21 0.62 -0.14 0.54 -0.27 0.50 -0.16 0.44 -0.20 0.34 0.14 0.30 0.03 0.15 0.19 -0.11 -0.10 -0.18 1.00 -0.71 0.24
Source: Bloomberg, Merrill Lynch, HFRI * - Entire table sorted in descending order by this column
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Introduction to Hedge Funds 22 June 2005 n Addressing Downside Risks While the Adjusted Long Run Sharpe ratio ranking may appear to have made hedge funds superior investments over our historical horizon, we still need to perform further analysis. We need to examine if the Sharpe ratio is the best measure of the return to variability tradeoff in hedge funds. The validity of the Sharpe ratio as a good measure of the return to variability tradeoff rests partly on the degree of symmetry in the return distribution being examined. The Normal distribution is a widely used distribution in statistics and has the important characteristic of being perfectly symmetrical around its mean. Its graph is a bell shaped curve with the peak of the bell located at the average of the distribution and its tapered sides indicate a decreasing probability of encountering extreme returns in the data. Chart A.1 shows a hypothetical Normal distribution (dashed line) and a hypothetical asymmetric distribution (solid line) of excess returns, each with the same monthly average return of 1% and monthly standard deviation of 2%.
Chart A.1: Normal & An Asymmetric Distribution with Mean = 1% and Std Dev = 2%
Normal and Asymmetric Distributions with Mean = 1% and Std. Dev = 2% 20 18 16 Probability Density 14 12 10 8 6 4 2 0 -0.25 -0.2 -0.15 -0.1 -0.05 0 0.05 Excess return over cash 0.1 0.15 0.2 0.25 Asymmetric Distribution Normal Distribution
The Normal distribution has equal area under the curve on both sides of the mean, whereas the asymmetric distribution has higher area below the mean. This asymmetry in a distribution is called Skewness and can be measured statistically. Any Normal distribution has a Skewness of 0.0, indicating perfect symmetry. In comparison, the asymmetric distribution shown in Figure 3 has Skewness of -1.14, which conforms to our visual hypothesis that this distribution has more observations below the mean. Due to the symmetry of the Normal distribution, standard deviation measures upside deviations as well as downside deviations from the mean equally well. However, standard deviation does not measure downside deviations from the mean as well for the asymmetric distribution. Since most investors associate risk in an investment with downside uncertainty and downside exposure, most investors would consider the asymmetric distribution riskier than the Normal distribution. This nuance of risk would not be picked up by an analysis of means and standard deviations or volatilities alone. In order to focus on the downside risk of a return distribution, we need a performance measure that appropriately accounts for downside risk. Another notable point about the Normal distribution is how the tails (the left and right ends of the graph) of the distribution rapidly taper off towards zero at its extremities. This contrasts with the relatively slower tapering in the case of the asymmetric distribution. Thus, it is extremely unlikely to find Normally distributed returns that are far removed from the center or mean of the distribution. However, the asymmetric distribution has a fatter left-tail, i.e., it has more area under the curve at more extreme return levels. This tendency towards extreme
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returns is known as Kurtosis can also be measured statistically. The Kurtosis of any Normal distribution is 3.0. Distributions with Kurtosis greater than 3.0 have at least one tail that is fatter than that of a Normal distribution. The asymmetric distribution shown above has a Kurtosis of 5.4. Kurtosis also reflects the volatility of volatility. For example, if we have 10 years of monthly returns for a particular investment and have estimated its historical volatility based on this data, a high Kurtosis value indicates that future volatility, for example volatility over the next 3 years, may be quite different from past volatility. Skewness and Kurtosis are best thought of as shape coefficients of a distribution of returns. Non-zero Skewness indicates asymmetry and Kurtosis greater than 3.0 indicates fat tails. Note that Skewness and Kurtosis values are ratios and therefore do not have any units. Estimated Skewness and Kurtosis values for our chosen strategies are shown in Table A.3, along with results of a standard statistical test of Normality of the distribution. It is clear from Table A.3 that most hedge fund styles did not have a Normal distribution of returns over the chosen horizon. These non-Normal distributions tended to have negative Skewness and Kurtosis greater than 3. Qualitatively, the shape of these non-Normal distributions is similar to that of the hypothetical asymmetric distribution shown in Chart A.1 above. Therefore, we need to assess the historical risk-reward tradeoff for such asymmetric distributions using measures that appropriately account for downside risk.
Table A.3: Skewness and Kurtosis (1/94 4/05)
Strategy Skewness Kurtosis* Test of Normality Jarque-Bera Test p-value outcome 0.0985 Passed 0.1414 Passed 0.1472 Passed 0.0033 Failed 0.0006 Failed 0.0015 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed
S&P 500 Index HFRI - Equity Market Neutral HFRI - Macro ML Domestic Master F.I. Index HFRI - Short Selling HFRI - Equity Hedge HFRI - Convertible Arbitrage HFRI - Fund Weighted Composite HFRI - Fund of Funds - Composite HFRI - Emerging Markets HFRI - Distressed Securities HFRI - Merger Arbitrage HFRI - Fixed Income - Arbitrage
Source: Bloomberg, Merrill Lynch, HFRI * - Entire table sorted in ascending order by this column
-0.57 0.29 0.07 -0.46 0.25 0.33 -1.04 -0.46 -0.19 -0.88 -1.55 -2.16 -3.07
3.43 3.51 3.77 3.80 4.64 4.72 4.81 5.89 7.14 7.57 11.23 12.81 19.20
One way of assessing the risk reward tradeoff in a given return distribution is to first set a threshold or hurdle rate of return and then calculate the ratio of average gains (i.e., mathematical expectation or average of returns above the hurdle rate minus the hurdle rate) to average losses (i.e., mathematical expectation or average of the hurdle rate minus returns below the hurdle rate.) This ratio is called the 6 Omega measure of the distribution and has been shown to account for all possible asymmetries in the return distribution being considered. It is the ratio of average gains, if we do have a gain, to average losses, if we indeed have a loss, where gains and losses are measured with respect to a pre-specified hurdle rate of return. Therefore higher values of Omega for any given hurdle rate are better even after taking into account negative Skewness and high Kurtosis.
6 Keating, C., W.F. Shadwick and A. Cascon, The Omega Function, The Journal of Performance Measurement, Spring 2002.
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Tables A.4 and A.5 below present Omega values and rankings respectively, for a range of hurdle rates and rankings of the different strategies based on the historical data we have used thus far. Tables A.4 and A.5 are sorted according to the Omega values and rankings corresponding to a 7.5% hurdle rate. Readers can visually inspect the Omega values and rankings for other hurdle rates as well. As can be seen below, hedge fund strategies had higher Omega values than either Stocks or Bonds for a range of different hurdle rates.
Table A.4: Omega Values (1/94 4/05)
Strategy HFRI - Distressed Securities HFRI - Equity Hedge HFRI - Merger Arbitrage HFRI - Fund Weighted Composite HFRI - Convertible Arbitrage HFRI - Macro S&P 500 Index HFRI - Emerging Markets HFRI - Equity Market Neutral HFRI - Fund of Funds - Composite HFRI - Short Selling ML Domestic Master F.I. Index HFRI - Fixed Income - Arbitrage
* - Entire table sorted in descending order by this column Source: Bloomberg, Merrill Lynch , HFRI
Omega Value Based on Annual Return Threshold -15.0% -10.0% -7.5% -5.0% 0.0% 5.0% 7.5%* 10.0% 28.08 17.93 13.69 10.23 5.29 2.69 1.92 1.38 12.71 7.89 6.24 4.98 3.21 2.11 1.72 1.42 47.23 27.36 19.62 13.68 6.19 2.61 1.62 0.97 16.89 9.35 7.10 5.38 3.19 1.91 1.49 1.17 51.25 24.00 16.36 11.06 5.14 2.27 1.45 0.90 14.62 8.46 6.43 4.91 2.86 1.70 1.32 1.04 3.53 2.71 2.39 2.12 1.68 1.34 1.20 1.07 3.74 2.84 2.49 2.19 1.70 1.32 1.17 1.04 495.09 79.27 41.60 23.34 6.89 2.06 1.15 0.66 21.04 10.65 7.40 5.22 2.62 1.36 0.98 0.71 2.05 1.67 1.51 1.37 1.14 0.96 0.88 0.81 42.91 18.95 12.30 7.98 3.25 1.35 0.87 0.55 24.41 13.64 10.12 7.35 3.38 1.27 0.71 0.39
15.0% 0.72 0.97 0.33 0.73 0.33 0.66 0.86 0.82 0.25 0.39 0.69 0.22 0.11
Table A.5: Omega Rankings (1/94 4/05)

Strategy HFRI - Distressed Securities HFRI - Equity Hedge HFRI - Merger Arbitrage HFRI - Fund Weighted Composite HFRI - Convertible Arbitrage HFRI - Macro S&P 500 Index HFRI - Emerging Markets HFRI - Equity Market Neutral HFRI - Fund of Funds - Composite HFRI - Short Selling ML Domestic Master F.I. Index HFRI - Fixed Income - Arbitrage
* - Entire table sorted in descending order by this column Table Notes: A high value of Omega is associated with a numerically lower rank Source: Bloomberg, Merrill Lynch , HFRI
Omega Rank Based on Annual Return Threshold -15.0% -10.0% -7.5% -5.0% 0.0% 5.0% 7.5%* 10.0% 5 5 4 4 3 1 1 2 10 10 10 9 7 4 2 1 3 2 2 2 2 2 3 7 8 8 8 7 8 6 4 3 2 3 3 3 4 3 5 8 9 9 9 10 9 7 6 5 12 12 12 12 12 10 7 4 11 11 11 11 11 11 8 6 1 1 1 1 1 5 9 11 7 7 7 8 10 8 10 10 13 13 13 13 13 13 11 9 4 4 5 5 6 9 12 12 6 6 6 6 5 12 13 13
15.0% 5 1 9 4 10 7 2 3 11 8 6 12 13
Importantly, as the hurdle rate increases, fewer hedge fund strategies are ranked above Stocks according to the Omega ratio. At a 0% hurdle rate all strategies except Short Selling ranked better than Stocks did. Additionally, 5 strategies ranked better than an investment in Bonds. At a 7.5% hurdle rate, Stocks ranked 7th and Bonds ranked 12th. At a 15% hurdle rate, Stocks ranked 2nd and Bonds ranked 12th. Our analysis thus shows that based on the Omega ratio, certain hedge fund strategies would have been preferred over Stocks and Bonds over our historical horizon. However, as the hurdle rate is increased, fewer hedge fund strategies had a higher Omega than Stocks. But even at a very high hurdle rate of 15%, Equity Hedge would still have been preferred to Stocks. Thus investors requiring a high hurdle rate would have had to be more selective about the
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strategies chosen compared to investors requiring moderate to low hurdle rates. Therefore, we can conclude that hedge fund strategies did have an attractive riskreward profile relative to Stocks and Bonds, even after accounting for the asymmetries and extreme returns that show up in hedge fund return distributions. An interesting question is, What causes the negative Skewness and high Kurtosis in hedge fund returns? Perhaps an intuitive way to understand this issue is to recall that hedge funds generally run concentrated portfolios and that their incentive structure is such that they prefer to make asymmetric investments. By asymmetric investments, we mean that hedge fund managers tend to invest in situations where there is a large chance of a modestly positive payoff and a relatively small chance of a large negative payoff. The average return of such an investment is positive and it has a moderately high level of volatility. When a small number of such investments are put together in a portfolio and each investment is relatively different or uncorrelated with each other, the hedge fund portfolio will have a modestly positive average return and low volatility. However, since the portfolio is concentrated, once in a while an investment will not work out as intended, resulting in a large negative return which cannot be fully overcome by the modestly positive return contributions of the other investments. Therefore, over time the portfolio is likely to exhibit some negative Skewnesss, due to the asymmetric investments in the portfolio, and high Kurtosis, due to the concentrated nature of the portfolio. n Results Using The CSFB/Tremont Family of Indices
Table A.6: Annualized Return Characteristics
Strategy Over full period examined* 1/94 - 4/05 13.73% 13.44% 11.57% 10.63% 10.31% 10.10% 8.82% 7.89% 7.62% 6.66% 6.62% -1.87% Compound Annualized Return Over high negative return Over high positive return period in Stocks period in Stocks 1/00 - 12/02 1/97 - 12/99 14.87% 11.81% 6.71% 13.19% -1.09% 27.97% 4.10% 15.70% -14.55% 27.56% 10.52% 14.49% 14.41% 8.29% 5.38% 9.51% 2.39% 4.55% 6.69% 4.03% 10.14% 5.74% 9.66% -6.79%
CSFB/T - Global Macro CSFB/T - Event Driven - Distressed CSFB/T - Long-Short Equity CSFB/T - Hedge Fund Index S&P 500 Index CSFB/T - Equity Market Neutral CSFB/T - Convertible Arbitrage CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Emerging Markets CSFB/T - Fixed Income Arbitrage ML Domestic Master F.I. Index CSFB/T - Dedicated Short Bias
Over last 5 years 5/00 - 4/05 16.12% 12.60% 4.66% 7.51% -2.94% 8.08% 7.42% 4.93% 10.00% 6.71% 7.52% 1.68%
Source: Bloomberg, Merrill Lynch * - Entire table sorted in descending order by this column
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Table A.7: Annualized Volatility Characteristics (1/94 4/05)

Strategy CSFB/T - Equity Market Neutral CSFB/T - Fixed Income Arbitrage ML Domestic Master F.I. Index CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Convertible Arbitrage CSFB/T - Event Driven - Distressed CSFB/T - Hedge Fund Index CSFB/T - Long-Short Equity CSFB/T - Global Macro S&P 500 Index CSFB/T - Emerging Markets CSFB/T - Dedicated Short Bias
Source: Bloomberg, Merrill Lynch * - Entire table sorted in ascending order by this column
Unadjusted Historical Standard Deviation (Volatility)* 2.99% 3.80% 3.95% 4.30% 4.82% 6.62% 8.06% 10.51% 11.43% 15.10% 16.82% 17.67%
Compound Annual Return 10.10% 6.66% 6.62% 7.89% 8.82% 13.44% 10.63% 11.57% 13.73% 10.31% 7.62% -1.87%
Table A.8: Serial Correlation in Returns

Strategy* Lag 1 0.56 0.11 0.30 0.29 0.29 0.27 0.39 0.06 0.12 0.17 0.15 0.00 Serial Correlation Value Lag 2 0.40 -0.04 0.02 0.19 0.13 -0.02 0.07 0.04 0.04 0.06 -0.11 -0.03 Lag 3 0.17 0.00 -0.01 0.09 0.02 -0.10 0.02 0.09 0.00 -0.04 0.10 0.07 Lag 4 0.13 -0.12 -0.07 0.03 0.01 -0.06 0.07 -0.09 -0.08 -0.10 -0.02 -0.07 Statistical Significance Ljung-Box p-value Serial Correlation at 1 lag at 5% significance 0.0000 Significant 0.2548 Insignificant 0.0080 Significant 0.0573 Insignificant 0.0081 Significant 0.0009 Significant 0.0000 Significant 0.9766 Insignificant 0.5579 Insignificant 0.1443 Insignificant 0.5250 Insignificant 0.9442 Insignificant
CSFB/T - Convertible Arbitrage CSFB/T - Dedicated Short Bias CSFB/T - Emerging Markets CSFB/T - Equity Market Neutral CSFB/T - Event Driven - Distressed CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Fixed Income Arbitrage CSFB/T - Global Macro CSFB/T - Hedge Fund Index CSFB/T - Long-Short Equity ML Domestic Master F.I. Index S&P 500 Index
Source: Bloomberg, Merrill Lynch * - Entire table sorted in alphabetical order by this column
Table A.9: Effect of Serial Correlation on Annualized Volatility

Strategy Unadjusted Historical Standard Deviation (Volatility)* 2.99% 3.80% 3.95% 4.30% 4.82% 6.62% 8.06% 10.51% 11.43% 15.10% 16.82% 17.67% Adjusted Long Run Standard Deviation (Volatility) 3.03% 4.55% 3.86% 5.19% 5.93% 7.42% 8.29% 11.71% 11.36% 15.96% 17.52% 19.46% Percent Change in Volatility due to Serial Correlation 1% 20% -2% 21% 23% 12% 3% 11% -1% 6% 4% 10%
CSFB/T - Equity Market Neutral CSFB/T - Fixed Income Arbitrage ML Domestic Master F.I. Index CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Convertible Arbitrage CSFB/T - Event Driven - Distressed CSFB/T - Hedge Fund Index CSFB/T - Long-Short Equity CSFB/T - Global Macro S&P 500 Index CSFB/T - Emerging Markets CSFB/T - Dedicated Short Bias
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Table A.10: Annualized Sharpe Ratios

Unadjusted Historical Sharpe Ratio 1.98 1.38 0.86 1.00 0.83 0.91 0.69 0.74 0.73 0.48 0.30 -0.24 Adjusted Long Run Sharpe Ratio* 1.95 1.23 0.86 0.81 0.81 0.76 0.70 0.66 0.60 0.45 0.29 -0.21 Percent Change in Sharpe ratio due to Serial Correlation -1% -11% 1% -19% -3% -17% 2% -10% -17% -5% -4% -9%
Strategy CSFB/T - Equity Market Neutral CSFB/T - Event Driven - Distressed CSFB/T - Global Macro CSFB/T - Convertible Arbitrage CSFB/T - Hedge Fund Index CSFB/T - Event Driven - Risk Arbitrage ML Domestic Master F.I. Index CSFB/T - Long-Short Equity CSFB/T - Fixed Income Arbitrage S&P 500 Index CSFB/T - Emerging Markets CSFB/T - Dedicated Short Bias
Table A.11: Skewness and Kurtosis

Strategy CSFB/T - Equity Market Neutral S&P 500 Index ML Domestic Master F.I. Index CSFB/T - Dedicated Short Bias CSFB/T - Hedge Fund Index CSFB/T - Global Macro CSFB/T - Convertible Arbitrage CSFB/T - Long-Short Equity CSFB/T - Emerging Markets CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Fixed Income Arbitrage CSFB/T - Event Driven - Distressed Skewness 0.31 -0.57 -0.46 0.83 0.13 0.01 -1.33 0.25 -0.61 -1.26 -3.18 -2.81 Kurtosis* 3.26 3.43 3.80 4.84 4.99 5.39 5.90 6.56 7.15 9.06 19.37 20.15 Test of Normality Jarque-Bera p-value Test outcome 0.2142 Passed 0.0985 Passed 0.0033 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed 0.0000 Failed
Table A.12: Omega Values (1/94 4/05)

Strategy CSFB/T - Event Driven - Distressed CSFB/T - Equity Market Neutral CSFB/T - Global Macro CSFB/T - Long-Short Equity CSFB/T - Hedge Fund Index CSFB/T Convertible Arbitrage S&P 500 Index CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Emerging Markets ML Domestic Master F.I. Index CSFB/T - Fixed Income Arbitrage CSFB/T - Dedicated Short Bias
-15.0% 19.12 N.M 7.15 8.61 12.58 20.53 3.53 34.00 3.10 42.91 25.99 1.97
-10.0% 12.71 374.60 5.11 5.61 7.70 11.76 2.71 17.41 2.42 18.95 14.64 1.54
-7.5% 10.07 102.48 4.33 4.54 6.02 8.75 2.39 12.60 2.15 12.30 10.69 1.37
Annual Return Threshold -5.0% 0.0% 5.0% 7.86 4.68 2.72 48.74 12.63 3.44 3.66 2.63 1.88 3.67 2.46 1.69 4.73 2.90 1.78 6.48 3.47 1.78 2.12 1.68 1.34 8.79 3.98 1.71 1.90 1.51 1.20 7.98 3.25 1.35 7.68 3.56 1.45 1.22 0.98 0.80
7.5%* 2.04 1.85 1.59 1.40 1.39 1.24 1.20 1.09 1.08 0.87 0.84 0.73
10.0% 1.53 1.04 1.34 1.17 1.10 0.85 1.07 0.70 0.96 0.55 0.45 0.66
15.0% 0.86 0.35 0.96 0.82 0.70 0.36 0.86 0.30 0.78 0.22 0.10 0.55
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Table A.13: Omega Rankings (1/94 4/05)

Strategy CSFB/T - Event Driven - Distressed CSFB/T - Equity Market Neutral CSFB/T - Global Macro CSFB/T - Long-Short Equity CSFB/T - Hedge Fund Index CSFB/T Convertible Arbitrage S&P 500 Index CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Emerging Markets ML Domestic Master F.I. Index CSFB/T - Fixed Income Arbitrage CSFB/T - Dedicated Short Bias
Source: Bloomberg, Merrill Lynch * - Entire table sorted in ascending order by this column Table Notes:: A higher value of Omega is associated with a numerically lower rank
Omega Rank Based on Annual Return Threshold -15.0% -10.0% -7.5% -5.0% 0.0% 5.0% 7.5%* 10.0% 6 5 5 4 2 2 1 1 1 1 1 1 1 1 2 6 9 9 9 9 8 3 3 2 8 8 8 8 9 7 4 3 7 7 7 7 7 5 5 4 5 6 6 6 5 4 6 8 10 10 10 10 10 10 7 5 3 3 2 2 3 6 8 9 11 11 11 11 11 11 9 7 2 2 3 3 6 9 10 11 4 4 4 5 4 8 11 12 12 12 12 12 12 12 12 10
15.0% 3 9 1 4 6 8 2 10 5 11 12 7
Table A.14: Correlation Analysis (1/94 4/05)

Strategy S&P 500 Index CSFB/T - Long-Short Equity CSFB/T - Event Driven - Distressed CSFB/T - Event Driven - Risk Arbitrage CSFB/T - Emerging Markets CSFB/T - Hedge Fund Index CSFB/T - Equity Market Neutral CSFB/T - Convertible Arbitrage CSFB/T - Global Macro CSFB/T - Fixed Income Arbitrage ML Domestic Master F.I. Index CSFB/T - Dedicated Short Bias
Unadjusted Historical Stocks 1.00 0.59 0.55 0.45 0.48 0.48 0.39 0.15 0.23 0.04 0.02 -0.76
Bonds 0.02 0.10 0.04 -0.06 -0.05 0.20 0.13 0.12 0.28 0.14 1.00 0.06
Adjusted Long Run Stocks* 1.00 0.60 0.56 0.55 0.50 0.47 0.43 0.15 0.12 -0.03 -0.18 -0.77
Bonds -0.18 -0.09 -0.19 -0.15 -0.22 0.00 0.03 0.01 0.17 -0.07 1.00 0.24
n Persistence Amongst Strategies The tables below show that there is tremendous variation in the set of strategies that did well in any particular year. Since business conditions and market opportunities vary by year, superior hedge fund strategy selection has the potential to add considerable value.
Table A.15: HFRI Indices - Annual Returns (1/94 12/04)
ML US Domestic Fund of Fund Equity Fixed Equity Emerging Short Income - Convertible Market Distressed Merger Weighted Funds - S&P 500 Master FI Index Macro Hedge Markets Selling Arbitrage Arbitrage Neutral Securities Arbitrage Composite Composite Index -4.30% 2.61% 3.38% 18.53% 11.94% -3.73% 2.65% 3.84% 8.88% 4.10% -3.48% 1.31% -2.83% 29.32% 31.04% 0.69% -17.14% 6.08% 19.85% 16.33% 19.73% 17.86% 21.50% 11.10% 37.43% 18.52% 9.32% 21.75% 27.14% -4.00% 11.89% 14.56% 14.20% 20.77% 16.61% 21.10% 14.39% 23.07% 3.59% 18.82% 23.41% 16.57% 3.86% 7.02% 13.96% 13.62% 15.40% 16.44% 16.79% 16.20% 33.37% 9.66% 6.19% 15.98% -32.96% -0.54% -10.29% 7.77% 8.30% -4.23% 7.23% 2.62% -5.11% 28.58% 8.87% 17.62% 44.22% 55.86% -24.40% 7.38% 14.41% 7.09% 16.94% 14.34% 31.29% 26.47% 21.03% -0.96% 1.97% 9.09% -10.71% 34.63% 4.78% 14.50% 14.56% 2.78% 18.02% 4.98% 4.07% -9.10% 11.73% 6.87% 0.40% 10.36% 8.99% 4.81% 13.37% 6.71% 13.28% 2.76% 4.62% 2.80% -11.87% 8.32% 7.42% -4.71% 3.70% 29.16% 8.77% 9.07% 0.98% 5.28% -0.86% -1.44% 1.01% -22.11% 10.41% 21.44% 20.53% 39.37% -21.77% 9.36% 9.93% 2.46% 29.58% 7.48% 19.55% 11.62% 28.69% 4.12% 4.33% 7.50% 18.80% -3.69% 5.82% 1.17% 4.28% 19.16% 4.11% 8.96% 6.75% 10.87% 4.34%
Year Ending Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04
36
Table A.16: HFRI Indices Strategies Ranked by Returns in Each Year (1/94 12/04) Higher rank corresponds to higher return relative to other strategies in the same year
ML US Domestic Fund of Fund Equity Fixed Income - Convertible Market Distressed Merger Weighted Funds - S&P 500 Master FI Index Arbitrage Arbitrage Neutral Securities Arbitrage Composite Composite Index 12 2 7 9 11 10 3 5 4 3 9 5 8 6 10 4 13 7 4 7 5 9 8 10 6 12 2 2 5 4 6 8 10 7 13 3 2 9 10 4 8 6 3 13 11 4 6 3 7 5 11 10 9 2 6 10 11 4 12 7 5 2 9 6 13 7 12 3 5 4 1 9 10 11 5 8 4 3 6 1 12 5 6 2 12 4 8 7 11 3 7 2 4 13 3 10 8 11 6
Equity Emerging Short Macro Hedge Markets Selling 1 6 8 13 11 12 2 1 3 11 13 1 11 12 9 1 7 12 1 5 8 12 13 1 3 8 1 13 8 2 11 10 9 2 7 13 10 9 13 1 5 9 12 1
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Table A.17: CSFB / Tremont Indices - Annual Return (1/94 12/04)

Fixed Income - Convertible Arbitrage Arbitrage 0.31% -8.07% 12.50% 16.57% 15.93% 17.87% 9.34% 14.48% -8.16% -4.41% 12.11% 16.04% 6.29% 25.64% 8.04% 14.58% 5.75% 4.05% 7.97% 12.90% 6.86% 1.98% ML US Equity Domestic Fund Market Distressed Merger Weighted S&P 500 Master FI Neutral Securities Arbitrage Composite Index Index -2.00% 0.67% 5.25% -4.36% 1.31% -2.83% 11.04% 26.12% 11.90% 21.69% 37.43% 18.52% 16.60% 25.55% 13.81% 22.22% 23.07% 3.59% 14.83% 20.73% 9.84% 25.94% 33.37% 9.66% 13.31% -1.68% 5.58% -0.36% 28.58% 8.87% 15.33% 22.18% 13.23% 23.43% 21.03% -0.96% 14.99% 1.95% 14.69% 4.85% -9.10% 11.73% 9.31% 20.01% 5.68% 4.42% -11.87% 8.32% 7.42% -0.69% -3.46% 3.04% -22.11% 10.41% 7.07% 25.12% 8.98% 15.44% 28.69% 4.12% 6.48% 15.62% 5.45% 9.64% 10.87% 4.34%
Macro -5.72% 30.67% 25.58% 37.11% -3.64% 5.81% 11.67% 18.38% 14.66% 17.99% 8.49%
Equity Emerging Hedge Markets -8.10% 12.51% 23.03% -16.91% 17.12% 34.50% 21.46% 26.59% 17.18% -37.66% 47.23% 44.82% 2.08% -5.52% -3.65% 5.84% -1.60% 7.36% 17.27% 28.75% 11.56% 12.49%
Short Selling 14.91% -7.35% -5.48% 0.42% -6.00% -14.22% 15.76% -3.58% 18.14% -32.59% -7.72%
Table A.18: CSFB / Tremont - Strategies Ranked by Returns in Each Year (1/94 12/04) Higher rank corresponds to higher return relative to other strategies in the same year
ML US Equity Domestic Fixed Fund Income - Convertible Market Distressed Merger Weighted S&P 500 Master FI Index Arbitrage Arbitrage Neutral Securities Arbitrage Composite Index 7 2 6 8 10 4 9 5 5 6 3 10 4 8 12 7 4 7 5 10 3 8 9 2 2 5 6 7 4 9 11 3 2 4 10 6 8 7 12 9 4 7 6 9 5 10 8 2 6 12 10 3 9 5 1 8 7 10 9 12 5 4 1 8 7 6 9 4 2 5 1 10 4 6 3 10 5 7 11 2 6 2 5 12 4 8 9 3
Macro 3 11 11 12 5 3 7 11 11 9 7
Equity Hedge 1 9 6 8 11 12 4 2 3 8 10
Emerging Markets 11 1 12 10 1 11 2 6 8 12 11
Short Selling 12 2 1 1 3 1 11 3 12 1 1
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7. Glossary
Active return: The difference between hedge fund returns and returns from an optimally tracking portfolio comprising only Stocks, Bonds and Cash. Active risk: The variation in active return. It stems from the differences in positions between the active portfolio and an optimally tracking portfolio of Stocks, Bonds and Cash. Alternative Risk Premia: These are additional returns that investors require to hold risky alternative investments. Buy and hold (B&H) strategy: A passive investment strategy in which an investor purchases the investment and holds it over the entire investment horizon. Constant proportions (CP) strategy: A dynamic investment strategy in which an investor periodically rebalances a portfolio to a fixed mix of investments. For example, an investor may start with a 60% allocation to Stocks and a 40% allocation to Bonds and then rebalance the portfolio annually to these proportions. Directional: This style of hedge funds derives returns from making combined decisions on market direction and security selection to varying degrees. The underlying markets could be currencies, commodities, equities or bonds. Draw-down: A reduction in a hedge funds net asset value from a previous high. Dynamic investment strategy: An investment strategy in which decisions are made at many points over the investment horizon. Event-Driven: Funds following this style position themselves to profit from analyzing and predicting the impact of significant corporate events such as spinoffs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks. They tend to invest across the entire spectrum of corporate securities such as bank debt, trade claims, bonds, preferred stock, common stock, options and warrants. Explicit leverage: Created by using borrowed funds or the proceeds of short sales to finance other investments in a portfolio. Implicit leverage: Created by using derivatives that have a leveraged and nonlinear payoff to movements in the price of the underlying asset. Investment strategy: A choice of allocations to investment choices over time. Leverage: A combination of two distinct notions. The first notion tries to capture the practice of using borrowed money to gain an economic exposure to an investment that is greater than the value of the investors cash commitment. The second notion tries to capture the ability to absorb potential losses. Liquidity Premium: This premium is generated by providing liquidity where needed, usually in markets with high transaction costs or long average investment holding periods. Lock-up: A commitment to keep the money in the fund for a specified period of time from commitment. Market Risk: Variation in the returns of the overall market; for example the equity market for an equity mutual fund. Market Based Returns: These are the returns from asset classes such as equities, bonds, currencies and commodities, without the use of leverage Operational efficiency: The ability to prioritize investment ideas, execute trades and manage risks in an efficient and low cost manner. Passive or static investment strategy: An investment strategy in which a decision is made only once at the beginning of the investment horizon. Relative valuation skill: The ability to detect mispricing and exploit inefficiencies amongst prices of similar financial instruments such as bonds, stocks or derivatives.
39
Relative Value: Hedge funds in this style derive the majority of their return from exploiting perceived pricing discrepancies between similar financial instruments. The underlying markets could be bonds, equities or their derivatives. Return Forecasting skill: The ability to generate and implement relatively accurate return forecasts at the security specific, sector or asset class level. Risk Transfer Premium: This premium is generated by taking on risk other market participants wish to avoid and is a form of asymmetric (i.e., one-sided) risk transfer. Selection bias: Voluntary reporting in hedge fund databases creates a selfselection bias. This means that some hedge funds will have no incentive to report their results while others have a strong incentive to do so. Sharpe ratio: The ratio of average returns in excess of cash equivalents such as 30-day US Treasury Bills to investment risk as measured by the standard deviation (also known as volatility) of returns. This ratio articulates the average return per unit of risk in an investment. Skill based returns: The portion of hedge fund returns derived from superior manager skill Spreads: Returns from the difference between two types of investments with different risk levels. They are created by isolating and investing solely in the spread. Survivorship bias: Some databases delete the historical records of closed funds, which makes the summary statistics (such as average returns) of the database look artificially better over time. This happens because funds generally close due to poor performance.
Important Disclosures
Copyright 2005 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). All rights reserved. Any unauthorized use or disclosure is prohibited. This report has been prepared and issued by MLPF&S and/or one of its affiliates and has been approved for publication in the United Kingdom by Merrill Lynch Pierce, Fenner & Smith Limited, which is authorized and regulated by the Financial Services Authority; has been considered and distributed in Australia by Merrill Lynch Equities (Australia) Limited (ABN 65 006 276 795), licensed under the Australian Corporations Act, AFSL No 235132; has been considered and distributed in Japan by Merrill Lynch Japan Securities Co, Ltd, a registered securities dealer under the Securities and Exchange Law in Japan; is distributed in Hong Kong by Merrill Lynch (Asia Pacific) Ltd, which is regulated by the Hong Kong SFC; and is distributed in Singapore by Merrill Lynch International Bank Ltd (Merchant Bank) and Merrill Lynch (Singapore) Pte Ltd (Company Registration No. 198602883D), which are regulated by the Monetary Authority of Singapore. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities or options or futures contracts. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.
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Introduction to Hedge Funds

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Hedge Fund Investment Strategies 4.

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

1. Introducing Hedge Funds

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Important features of hedge fund investments are summarized below.

Restricted access Lack of standardized industry-wide reporting Lower transparency

Shorter data histories

Skill based returns

Higher fees Tax issues

Source: Merrill Lynch

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

2. Size and Growth of Hedge Funds

Chart 2: Growth in Number of Hedge Funds

Compound Annual Growth Rate = 24%

820 800 Assets, $ Billion

4,598 3,904 3,335 3,102

Source: HFRI (www.hedgefundresearch.com); Note: Excludes Funds of Hedge Funds

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Source: Edhec Risk, Merrill Lynch

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

3. Salient Features of Hedge Funds

Portfolio management flexibility

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Fee structure flexibility

n Hedge Funds Use Leverage, But Practical Considerations

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

4. Hedge Fund Investment Strategies

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Hedge Fund Gross Returns

Market Based Returns

Alternative Risk Premia

Risk Transfer Premium

Source: Merrill Lynch

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Source: Merrill Lynch

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Relative Value, 30%

Source: HFRI (www.hedgefundresearch.com), Merrill Lynch

Relative Value Strategies

Refer to important disclosures on page 40.

Introduction to Hedge Funds 22 June 2005

Refer to important disclosures on page 40.