INVESTMENT VOLATILITY: ARE ALTERNATIVES AN ALTERNATIVE

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INVESTMENT VOLATILITY ARE ALTERNATIVES AN
ALTERNATIVE?

• Council on Foundations Annual Conference
• April 28, 2003
• Edward B. Kacic, Irvine Health Foundation
• Bruce Madding, Kaiser Family Foundation
• Jim Martin, M.J. Murdock Charitable Trust

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Todays Discussion

• What Well Cover
• Alternatives 101
• Introduce Concepts
• Discuss Types of Alternative Assets
• Discuss Use of Alternatives
• Discuss Benefits and Potential Pitfalls

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Todays Discussion

• What We Wont Cover
• Investments 101
• Basic Asset Allocation
• In-Depth Details of Sub-Strategies
• Sales Pitches for Specific Products

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Glossary What We Mean

• Volatility Standard deviation of returns
• Correlation Coefficient Degree to which assets
  move in relation to one another (always expressed
  as range of -1 to 1)
• Alpha Excess return (e.g., returns that exceed
  benchmark)

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Glossary What We Mean

• Beta Sensitivity of an asset/portfolio to the
  movement of the market (Market beta equals 1.
  Beta of 1.1 indicates asset is expected to move
  10 more than the market)

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What Are Alternatives?

• Non-traditional Strategies
• Debt, Equity, and/or Real Assets
• Lower Correlation to Traditional Assets
• Can Contribute to Lower Portfolio Volatility
• Can Contribute to Higher Expected Return

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Types of Alternative Investments

• Commonly Described
• Private Equity
• Private Debt
• Venture Capital
• Absolute Return
• Hedge Funds
• Real Estate
• Natural Resources
• Commodities/Futures

• Well Call Them
• Private Equity
• Hedge
• Real Assets
• Not Discussed Here

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Investment Methodologies

• Direct Investment
• Partnerships
• Funds
• Funds of Funds

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Considerations

• Asset Allocation
• Liquidity
• Finding Appropriate Investments
• Minimum Investment Requirements

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Considerations

• Expected Returns
• Performance Evaluation
• Fees
• Legal Issues

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Types of Alternative Investments

• Commonly Described
• Private Equity
• Private Debt
• Venture Capital
• Absolute Return
• Hedge Funds
• Real Estate
• Natural Resources
• Commodities/Futures

• Well Call Them
• Private Equity
• Hedge
• Real Assets
• Not Discussed Here

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Council on Foundations54th Annual
ConferenceDallas, TexasApril 28 30,
2003

• Investment Volatility
• Are Alternatives an Alternative?
• Jim Martin
• 400 pm 530 pm
• Monday, April 28, 2003

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Discussion

• Jim Martin Background
• M. J. Murdock Charitable Trust
• Overview
• Asset Allocation Policy/History
• Return Expectations/Risk
• Volatility
• Alternatives - Traditional Asset Classes

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Discussion

• Alternatives M. J. Murdock Charitable Trust
• Alternatives Issues to Consider
• Direct or Fund-of-Funds Investing
• Performance Measurement Considerations
• Historical Returns

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Jim Martin Background

• Deloitte Touche
  (formerly, Deloitte Haskins Sells)
• 18 years
• Partner
• M. J. Murdock Charitable Trust
• 1987 Present
• Chief Investment and Financial Officer

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Jim Martin Background

• Registered Investment Advisor
• Manage Approximately 125 million on Fully
  Discretionary Basis
• Investment Committees
• Sunkist (200 mil)
• Rasmuson Foundation (425 mil)
• Boy Scouts Cascade Pacific Council (1.2 mil)
• Vancouver Rotary Foundation (1.2 mil)
• Red Cross Clark County, Washington (1.4 mil)
• Community Foundation of Southwest Washington (30
  mil)

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M.J. Murdock Charitable Trust Overview

• Private Foundation
• Vancouver, Washington
• 460 Million
• Formation
• Jack Murdocks Estate - 1975
• Tektronix Co-Founder
• Assets at Inception
• 91 million
• Grantmaking
• Five Northwest States
• Cumulative Grants Since Inception 386 million
• Primarily Scientific Research and Education

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M.J. Murdock Charitable TrustAsset Allocation
Policy/History
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M.J. Murdock Charitable TrustReturn
Expectations/Risk
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Volatility

• Volatility
• Not Your Friend
• Career Risk
• Standard Deviations Measurement
• Extreme Volatility
• Any Asset
• Any Investment
• Biggest Risk
• Not Having Dollars When Needed

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Volatility

• Minimizing Volatility
• Multiple Asset Classes
• Asset Class Diversity
• Use Alternatives
• Non-Product Correlation
• Asset Class Return Guarantee

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Alternatives Traditional Asset Classes

• Alternatives Non-Traditional Products
• Not Long Only Bonds or Equities
• Looks Like A Duck Sounds Like a Duck
  Alternative
• Modeled Risk/Return Characteristics
• Asset Class
• Capital Preservation
• Murdock Trust Example

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Alternatives M. J. Murdock Charitable Trust

• Various Options
• M. J. Murdock Charitable Trust Structure
• Private Equity
• Venture Capital
• Private Placements
• Oil and Gas
• Mezzanine
• Secondaries
• Global
• Distressed Securities
• Hedge Funds
• Other

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AlternativesIssues to Consider

• Liquidity Need
• Cash Flow
• Building the Class and Distributions back
• Commitment Sizes
• 10- to 15-year Product Commitments
• Valuations
• Daily, Monthly, Quarterly, Annual
• Perceptions
• Constituency
• Other Interested Parties

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Direct or Fund-of-Funds Investing

• Invest Direct
• For the Big Boys
• Significant Assets
• Minimum Requirements
• Prudent Diversification
• Diversification
• Type
• Vintage Year

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Direct or Fund-of-Funds Investing

• Fund-of-Funds
• Diversification
• Expertise
• Due Diligence Leveraging
• Fees

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Performance Measurement Considerations

• Private Equity Investments
• Not Marked to Market
• Best Measurement
• IRR?
• Time Weighted Returns?
• Cash Flow Multiples?
• Combination Thereof or Hybrid?
• Combining Alternative and Traditional Asset Class
  Return

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Historical Returns
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Historical Returns
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Questions?
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Types of Alternative Investments

• Commonly Described
• Private Equity
• Private Debt
• Venture Capital
• Absolute Return
• Hedge Funds
• Real Estate
• Natural Resources
• Commodities/Futures

• Well Call Them
• Private Equity
• Hedge
• Real Assets
• Not Discussed Here

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What really is a hedge fund?

• The term hedge fund is a catchall that applies
  to thousands and thousands of investment funds of
  all strategies. A hedge fund can be any limited
  partnership thats constructed in such a way as
  to give the general partners the managers of
  the fund a share of the profits earned on the
  limited partners money.
• - Andy Serwer Carol Loomis, Fortune

Council on Foundations April 28, 2003
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Hedge Funds Defined

• Private pooled investment vehicles
• Short positions, derivatives, leverage, hedging,
  arbitrage
• Normally charge an incentive fee based on fund
  performance
• Specialized, skill-based alternative investment
  strategies
• Seek to capitalize on pricing inefficiencies

Source Northern Trust CIS Conference 2001
Council on Foundations April 28, 2003
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Why Invest?

• Diversification of equity market risk
• Higher comparative liquidity
• Positive returns in negative market environments

Source Northern Trust CIS Conference 2001
Council on Foundations April 28, 2003
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Short Term Performance
Source EIM Group Presentation, The Promise and
the Reality of Hedge Fund Investing
Council on Foundations April 28, 2003
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Long Term Performance
Source EIM Group Presentation, The Promise and
the Reality of Hedge Fund Investing
Council on Foundations April 28, 2003
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Hedge vs. Greater Market
HFRI vs. Greater Market Indices
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Historical Risk/Returns
Source EACM
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Steps to develop a hedge fund portfolio

• Articulate your investment beliefs
• Management of complexity
• Understanding all the strategies
• Automation, database management, well-defined
  processes
• Search for unique sources of alpha
• Undertaking individual manager due diligence
• Advanced Portfolio Construction
• Name, measure and immunize the portfolio from as
  many potential shocks as possible
• Structuring the portfolio to meet the
  organizations risk and return expectations
• - Northwater Capital Management

Council on Foundations April 28, 2003
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Alternative Asset Program Objectives

• Define Objectives of the Program
• Diversification
• Low correlation to equity market
• Low volatility to equity market
• Expected return inflation 8

• AGGRESSIVE
• Outperform broad equity
• market w/ 60-80 of volatility
• Significant directional risk

• CONSERVATIVE
• Low volatility/low return
• Emphasis on diversification

• MODERATE
• Some equity market directional risk
• Volatility 1/3 of equity market

Council on Foundations April 28, 2003
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Hedge Fund Categories

• Relative Value
• Long/Short Equity
• Convertible Arbitrage
• Fixed Income Arbitrage
• Market Neutral Equity Arbitrage
• Multi-Strategy Hedge
• Event-Driven
• Deal Arbitrage
• Bankruptcy/Distressed
• Multi-Strategy
• Equity Hedge Funds
• Long Biased
• Opportunistic
• Global/International
• Global Asset Allocators
• Discretionary
• Systematic
• Short Selling

Council on Foundations April 28, 2003
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Hedge Fund Spectrum
Hedge funds cover a broad spectrum of risk/return
characteristics
Global Macro
Emerging Equities Managed
Futures Dedicated Short Bias
Market Timing Long/short
Equity Distressed Securities Fixed Income
Arbitrage Convertible Arbitrage
Merger Arbitrage Equity Market Neutral
Return
Low Volatility High
Council on Foundations April 28, 2003
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Choosing Appropriate Strategies
Define Objectives of the Program

• Conservative Strategies
• - Distressed Securities (Senior)
• Diversified Arbitrage
• (Low/No Leverage)
• Event Arbitrage
• Market Neutral
• (Broad Market Sectors)

• Moderate Strategies
• Convertible Arbitrage
• Distressed Securities (Post Bankruptcy)
• Diversified Arbitrage
• (Some Leverage)
• Event Arbitrage (Higher Risk Deals)
• Market Neutral
• Short-Biased
• Long/short US Equity (No Leverage)

• Aggressive Strategies
• Global Long/Short
• Global Macro (Leveraged)
• Long/short US Equity (Concentrated Value or
  cap-size focus)
• Sector Funds
• (Sector Directional Risk)

Council on Foundations April 28, 2003
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Kaiser Hedge Allocations
Council on Foundations April 28, 2003
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Diversification through Partnerships and Fund of
Funds
Conservative Strategies
Moderate Strategies
Aggressive Strategies
Defined Target Allocations for each strategy (8
to 10 funds total)
Partnership Investments Only
Fund of Funds and Partnerships
Fund of Funds Only

• Achieve Objectives of the Program
• Diversification
• Low correlation to equity market
• Low volatility to equity market
• Expected return inflation 8

Council on Foundations April 28, 2003
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Accessing Absolute Return Strategies

• Direct Investment
• Pros Greater Control
• Cons Research intensive, administratively
  burdensome, manager cross correlation
• Consultant
• Pros Greater diversification, consolidation of
  information
• Cons Not fully immersed in industry knowledge,
  probable manager cross correlation
• Fund of Funds
• Pros Low correlation b/w managers, greater
  liquidity, low minimum investment increases
  access for smaller investors, consolidation of
  information, expertise
• Cons Higher fees

Council on Foundations April 28, 2003
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Due Diligence

• Try to determine whether past performance is
  sustainable
• Look at stability
• Administration and back office
• Minimum 3 year track record preferable
• Evaluate qualitative ability in judgment

Council on Foundations April 28, 2003
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Risks

• Blundered, blown-up or defrauded
• investors at fairly regular intervals
• - The Economist
• Chicago Art Institute
• Lipper
• Long Term Capital
• Askin Capital
• Eifuku

Council on Foundations April 28, 2003
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Eifuku good fortune?

• Eifuku Master Fund, a 300 million hedge fund,
  in Japan is being wound down after losing
  virtually all its capital in just seven trading
  days in early January. The swift reversal in the
  fund, which was up 76 in 2002, shows just how
  volatile hedge funds can be.
• - Henny Sender Jason Singer, Wall
  Street Journal

Council on Foundations April 28, 2003
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Failed Funds

• Overall about 750 hedge funds closed up shop
  last year, or about 14 of all funds, up from
  11
• - Henny Sender Gregory Zuckerman, Wall
  Street Journal

Council on Foundations April 28, 2003
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Optimization

• As with real estate and private equity, hedge
  funds offer optimization techniques to imperfect
  input data for all three parameters, risk, return
  and correlation. This is due to infrequent and
  sometimes imperfect mark-to-markets, survivor
  bias and relatively short return histories.
• - Northwater Capital Management

Council on Foundations April 28, 2003
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Risks

• Whether or not it is a bubble or a gold rush no
  one disputes that it is certainly a craze
• - Growing concerns that not all the money that
  has been raised can be allocated

Council on Foundations April 28, 2003
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Risks

• You Cannot Scale Talent
• - Stephen Oxley of Watson Wyatt
• Headline Risk
• No Transparency
• Higher Costs
• Turnover

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Fierce secrecy

• My client called up this hedge fund he had a big
  chunk of money in to ask generally about its
  positions and they basically told him, None of
  your business. And it was his money!
• - Anonymous fund of funds manager

Council on Foundations April 28, 2003
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Survey of Pension Plans
Does your plan allocate or intend to allocate to
higher risk strategies like alternative
investments private equity, venture capital, and
hedge funds?
The survey was conducted on 205 investment
officers from corporate, public, and union funds.
12 of funds reporting held more than 10
billion in assets, 42 had 1-9.9 billion, 21
had 500 million - 1 billion, and 25 had 200
million - 499 million.
Council on Foundations April 28, 2003
Source Fidelity Viewpoint, Winter 2003
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Bibliography/Resources

• Pioneering Portfolio Management An Unconventional
  Approach to Institutional Investment. David F.
  Swensen. The Free Press, 2000.
• Hedge Funds Investment and Portfolio Strategies
  for the Institutional Investor. Jess Lederman
  Robert Klein, editors. Irwin Professional
  Publishing, 1995.
• The Handbook of Alternative Investment
  Strategies. Thomas Schneeweis, Joseph F.
  Pescatore, editors. Institutional Investor, 1999.

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Bibliography/Resources

• Evaluating and Implementing Hedge Fund
  Strategies, second edition. Ronald A. Lake,
  editor. Euromoney books, 1999.
• The Money of Invention How Venture Capital
  Creates New Wealth. Paul A. Gompers and Josh
  Lerner. Harvard Business School Press, 2001.

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Bibliography/Resources

• Journal of Alternative Investments.
  Institutional Investor. www.iijai.com.
• National Assn. of Real Estate Investment Trusts
  www.nareit.com
• National Council of Real Estate Investment
  Fiduciaries www.ncreif.com

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Bibliography/Resources

• Managed Account Reports www.marhedge.com
• Venture Capital Institute www.vcinstitute.org
• Venture Economics www.ventureeconomics.com