Sam Y' Chung, Ph'D'

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CISDM First Annual Korea Hedge Fund Conference
Sam Y. Chung, Ph.D. Assistant Professor of
Finance, Long Island University Research
Associate/CISDM CISDM/University of
Massachusetts-Amherst Amherst, Massachusetts
01003 Ph 718-488-1149 Email SAM.CHUNG_at_LIU.EDU
Web WWW.CISDM.ORG
THE PRESENTATION IS BASED ON INFORMATION OBTAINED
FROM SOURCES THAT CISDM CONSIDERS TO BE
RELIABLE HOWEVER, CISDM MAKES NO REPRESENTATION
AS TO, AND ACCEPTS NO RESPONSIBILITY OR LIABILITY
FOR, THE ACCURACY OR COMPLETENESS OF THE
INFORMATION.
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Background
Dr. Chung is an Assistant Professor of Finance at
Long Island University, as well as a research
associate of CISDM and Editorial Board Member of
the Journal of Alternative Investments. Dr.
Chung is also Senior Research Analyst and
Advisory Board Member of SSARIS Advisors LLC.  He
received his Ph.D. in Finance from the University
of Massachusetts-Amherst, Master of Finance from
Boston College, and M.B.A from Illinois State
University. He has published various articles in
journals such as the Journal of International
Business and Finance, the Journal of Alternative
Investment along with numerous research and
consulting endeavors in the area of financial
risk management and measurement. His current
research interests include Risk Measurement
(VaR) and Management through Derivatives Markets,
Alternative Investment (Hedge Funds, CTAs,
Managed Futures, etc.) strategies, Futures Market
Microstructure, and International Banking and
Finance.
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The First CISDM Seminar in Korea
Outline

• Introduction to Traditional and Alternative
  Investments
• II. Source of Hedge Fund Returns
• III. Issues in Hedge Fund Performance
• IV. Issues in Asset Allocation

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I. Introduction to Traditional and Alternative
Investments
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Academic Evidence on Traditional Investments

• Actively Managed Stocks and Bond Portfolios
  Provide Little Alpha (Excess Return Relative to
  Benchmarks)
• Stock and Bond Investment Do Not Provide
  Consistent Diversification

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Little Evidence of Equity Fund Alpha (1996-2001)
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Little Evidence of Fixed Income Fund Alpha
(1996-2001)
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Little Evidence of Diversification Benefits
Across Countries
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Hedge Funds Versus Traditional Investments

• Source of Alpha Relative to Traditional
  Investments
• Unique Return Opportunities
• Strategy Based
• Manager Based
• Source of Unique Diversification Opportunities
• Different Source of Return
• Use Wider Range of Instruments (e.g., Futures,
  Options, etc.)

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Evidence of Hedge Fund Alpha (1990-2001)
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Evidence of Diversification Benefits
12
Evidence on Hedge Funds

• Actively Managed Hedge Fund Portfolios Provide
  Alpha (Excess Return Relative to Benchmarks)
• Hedge Funds Provide Diversification To
  Traditional Investments

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II. Source of Hedge Fund Returns

• Hedge Fund Performance
• Performance Attribution
• Performance in Extreme Environments

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Hedge Fund Indices
EACM 100 Hedge Fund Research CSFB SP Hedge
Fund Index MSCI
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Hedge Fund Performance
Performance
Lehman Gov./Corp
Lehman
EACM 100
SP 500
MSCI
January, 1990-December, 2001
Bond
Global Bond
Annualized Return
13.8
12.9
8.1
6.5
6.9
Annualized Stdev
4.3
14.6
4.2
14.6
4.9
Sharpe Ratio
1.95
0.51
0.62
0.07
0.31
Minimum Monthly Return
-4.5
-14.5
-2.5
-13.4
-3.0
Correlation With EACM 100
0.39
0.17
0.39
0.06
Portfolio I
Portfolio II
Portfolio III
Portfolio IV
SP 500
SP 500, Lehman Bond
MSCI and
MSCI, Lehman Global Bond
Lehman Bond
and EACM 100
Lehman Global Bond
and EACM 100
Annualized Return
10.71
11.37
6.98
8.37
Annualized Stdev
8.12
6.89
8.40
7.08
Sharpe Ratio
0.65
0.86
0.18
0.41
Minimum Monthly Return
-6.25
-5.89
-5.63
-5.39
Correlation With EACM 100
0.40
0.36
Portfolio I 50 SP 500 and 50 Lehman
BrothersGov./Corp. Bond
Portfolio II 40 SP 500, 40 Lehman Brothers
Gov./Corp. Bond and 20 EACM 100
Portfolio III 50 MSCI and 50 Lehman Brothers
Global Bond
Portfolio IV 40 MSCI, 40 Lehman Brothers
Global Bond and 20 EACM 100
EACM 100 Index of Hedge Fund Strategies
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Hedge Fund Performance
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Hedge Fund Strategies (see Appendix)

• Relative Value
• Market Neutral Equity (Long undervalued/short
  overvalued)
• Convertible Hedging (Long convertible
  bonds/short stock)
• Bond hedging (Yield curve arbitrage)
• Event Driven Corporate transactions and special
  situations
• Merger Arbitrage (Corporate transactions)
• Distressed (Long securities involved in
  financial distress)
• Multi-strategy (Deal arbitrage and bankruptcy)
• Equity Hedge Funds
• Domestic Long (Long undervalued US equities)
• Domestic Opportunity (Long/Short Equity (long
  bias))
• Global Asset Allocators/Global Macro
• Systematic (Trend-following or other
  quantitative analysis)
• Discretionary (Fundamental analysis)

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Hedge Fund Performance
19
Hedge Fund Performance Within Hedge Funds
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Basis for Hedge Fund Performance Sensitivity to
Different Factors
Multi-Factor Models Can Be Used To Describe
Sources of Fund Return (e.g., Sharpe Style
Factors)
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Hedge Funds Returns in Extreme Market
Environments
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III. Issues in Hedge Fund Performance

• Performance Persistence
• Alpha Determination
• Fund of Fund

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Hedge Fund FOF Little Evidence of Performance
Persistence
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Hedge Funds Little Evidence of Performance
Persistence
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Alpha Exist but is Reduced When Corrected For
Market Factors (CISDM Fund of Fund Index)
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Alpha Exist but is Reduced When Corrected For
Market Factors (CISDM Fund of Fund Index)
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Diversified Fund of Funds Market Timers
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Style Pure Fund of Funds Constant Sensitivity
to Market Factor
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IV Issues in Asset Allocation

• Fund weights determined by return or risk
  preferences
• Fund weights determined by return/risk
  optimization
• Asset allocation determined by common security
  characteristics
• Fund selection determined by forecasts of
  economic conditions

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Hedge Funds Return Enhancers and Risk Reducers
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Traditional Mean Variance Optimization with Hedge
Funds
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Hedge Funds Replace Traditional Assets with
Similar Security Characteristics Change in
Allocation
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Hedge Funds Replace Traditional Assets with
Similar Security Characteristics Change in
Allocation
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Relative Alpha When Hedge Funds Replace
Traditional Assets with Similar Security
Characteristics
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Tactical Asset Allocation
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Strategic Asset Allocation
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Summary

• Traditional Means of Risk and Return Analysis
  Works for Alternative Investments.
• Each Strategys Returns and Risks are Dependent
  on Markets they Trade and the Leverage they take
• Multi-factor Models which Describe Return Process
  for Stocks and Bonds also Describe the Return
  Process for Alternative Investments
• Modern Methods of Asset Allocation can be used
  to Deliver Desired Risk and Return Tradeoff

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Appendix Hedge Fund Index Classification
Convertible Arbitrage Strategy attempts to
exploit anomalies in prices of corporate
convertible securities, such as convertible
bonds, warrants and convertible preferred stock.
Managers in this category buy or sell these
securities and then hedge part or all of the
associated risks. These risks include changes in
the price of the underlying stock, changes in
expected volatility of the stock, changes in the
level of interest rates and changes in the credit
standing of the issuer. The delta of a long
position in the convertible security is typically
hedged by selling the stock short. Many managers
strive for a delta-neutral position, but some
deliberately over-hedge. Over-hedging is
appropriate when there is concern about default,
as the excess short position may partially hedge
against a reduction in credit quality. Convertible
arbitrage strategies will typically 1) make
money if expected volatility increases (long
vega) 2) make money if the stock price increases
rapidly (long gamma) and 3) pay time-decay
(short theta). Depending on the hedge strategy,
the strategy will also make money if the credit
quality of the issuer improves (short the credit
differential). While there are occasionally
instances where a manger will short the
convertible security and long the underlying
stock, the trade is almost always conducted by
owning the convertible and shorting the stock.
The evidence on why convertible bonds should be
systematically underpriced focuses on market
segmentation. The market segmentation hypothesis
suggests that the markets for different types of
securities, such as stocks and bonds, are not
closely integrated. Securities that do not
change type through time will be preferred to
securities that change their types. Convertible
bonds frequently change type. If the issuer
does well, the bond behaves like a stock. If the
issuer does poorly, the bond becomes distressed
debt. If little happens, it behaves like a bond.
It should not be surprising that investors
discount these securities, as they understand
there is a high probability that a given
convertible will change type at least once during
the life of the security. What the segmentation
hypothesis cannot explain is why companies
continue to issue convertible securities if the
market discounts them relative to offering a
combination of stock and non-convertible debt.
There are many possible explanations for this
phenomenon, but the underlying cause is not
central to the argument that convertible
arbitrage has a natural rate of return. As long
as convertible securities remain underpriced, a
strategy that purchases the debt and hedges
associated risks should earn positive
risk-adjusted returns.
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Appendix Hedge Fund Index Classification
Merger Arbitrage Also called deal arbitrage,
seeks to capture the price spread between current
market prices of corporate securities and their
value upon successful completion of a takeover,
merger, spin-of, or similar transaction involving
more than one firm. In merger arbitrage, the
opportunity typically involves buying the stock
of target companies after a merger announcement
and shorting an appropriate amount of the
acquiring companys stock. The common stock of
target companies typically trades at a discount
to the present value of the merger offer. This
discount principally reflects the probability
that the merger will not be consummated, though
there are a number of other factors that
influence the relationship between the present
value of the merger offer and the target stock
price. Included in this are the probability that
a higher offer may be negotiated, either with the
original acquiring firm or with a different
suitor, which would tend to increase target stock
price, and the difficulty involved in hedging
the transaction, which would tend to decrease the
target price. Strategies for mitigating these
risks vary across managers. Some attempt to
diversify this risk away by holding a large
portfolio of different deals. Others focus on a
few deals and attempt to estimate the exact
probability that a particular merger will take
place. Evidence on the success of merger
arbitrage strategies typically finds that a
diversified portfolio of hedged merger positions
will earn excess returns over time. Market
segmentation is frequently cited as a reason that
target companies trade at a discount. The risks
associated with merger arbitrage are different
from the risks associated with analyzing common
tock. Most equity investors are not comfortable
with analyzing and bearing the risks associated
with merger arbitrage, as their valuation models
are not well suited to estimating the probability
that a merger will fail, and their portfolios do
not contain enough merger positions to diversify
this risk away. As such, holders of the target
company are generally willing to accept a small
discount to fair value in order to shift those
risks to arbitrage specialists who are better
able to manage those risks.
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Appendix Hedge Fund Index Classification

• Distressed Securities
• Portfolios invest in both debt and equity of
  companies that are in or near bankruptcy. These
  investments include
• 1. Purchasing the securities of companies that
  are near, in, or emerging from bankruptcy (the
  most common investment)
• 2. Owning the securities of companies that are in
  bankruptcy and participating in the bankruptcy
  proceedings
• 3. Shorting the securities of companies that are
  believed to be near bankruptcy (although
  difficult because the relative illiquidity of
  distressed debt and equity) and
• Selling short one class of a distressed companys
  capital structure and purchasing another (as a
  relative value opportunity).
• Distressed debt and equity securities are
  fundamentally different from non-distressed
  securities. Most investors are unprepared for
  the
• legal difficulties and negotiations with
  creditors and other claimants that are common
  when dealing with distressed companies. These
• risks require unique skills and investors
  generally prefer to transfer those risks to
  specialists in the distressed market when a
  company is
• in danger of default. Further, many investors
  are prevented by charter from holding securities
  that are in default or at risk of default.
• Because of the relative illiquidity of distressed
  debt and equity, short sales are difficult, and
  most funds are primarily long. Some relative
• value trades are possible, selling short one
  class of a distressed companys capital structure
  and purchasing another. Among the many
• risks associated with distressed investing are
  the time lag between when an investment is made
  and when the value of the
• investment is realized and the legal, and other
  monitoring costs that are involved in protecting
  the value of the funds claims. Many
• funds mitigate these risks through
  diversification holding a widely diversified
  portfolio of distressed assets on the assumption
  that, on
• average, these securities will prove to be
  underpriced.

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Appendix Hedge Fund Index Classification
Event Driven Strategy focuses on identifying
investment opportunities that benefit from
specific events or market conditions. For
instance, in the broader perspective, event
driven strategies often concentrate on taking
positions in firms that are or are anticipated to
be involved in mergers, bankruptcies or other
special situations. Hedge fund managers that
specialize in distressed securities or merger
arbitrage also fall under this classification.
The Event Driven Index consists of hedge fund
managers who follow multiple event strategies.
These strategies may involve restructurings or
recapitalizations, spin-offs or carve-outs, and
directional positions that may not be fully
arbitraged. Thus, the returns to this group of
hedge fund managers may be based on fundamental
research as well as directional market returns,
while deal arbitrage funds are expected to hedge
the exposure to market direction.
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Appendix Hedge Fund Index Classification

• Hedged Equity
• Funds follow a wide variety of strategies. The
  Index focuses on a subset of funds that hedge at
  least some portion of market exposure
• with short sales or exchange-traded futures and
  options. The funds included in the Zurich Hedged
  Equity Index focus on directional
• long and short without the explicit intention to
  have a zero exposure to the market as a whole.
  Historically, Hedged Equity managers
• have tended to have a net long market
  exposure.The primary economic sources of return
  to Hedged Equity (beyond merely holding
• dividend-generating or otherwise appreciating
  assets) derive from three distinguishing
  characteristics of the strategy
• The ability to hold illiquid assets and capture
  corresponding risk premia
• 1. The ability to effectively employ short
  positions and
• 2. The ability to utilize financial instruments
  (e.g. options, OTC derivatives) not readily
• available to traditional long-only money
  managers.
• In short, Hedged Equity funds derive returns
  beyond traditional equity-based money managers by
  holding asset positions and by
• bearing types of risks that other asset managers
  are less willing or otherwise unable to assume.
  The ability of Hedged Equity funds
• to earn these returns has developed over time, as
  advances in securities lending, financial
  innovation, and changes in regulation have
• enabled Hedged Equity funds to better determine
  and implement target positions. The ability to
  hold illiquid assets and capture
• corresponding risk premia

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Appendix Hedge Fund Index Classification
Equity Market Neutral Managers will base the
investment decision on their view of the degree
by which individual securities are under or over
valued relative to current market prices. These
strategies are heavily reliant on the skill of
the manager in discerning the value of a
securities. The manager may use quantitative
tools, however the final investment decision is
usually a subjective one. This investment
strategy is designed to exploit equity market
inefficiencies and usually involves
simultaneously long and short matched equity
portfolios of the same size. The manager will
aim to position the portfolio to be cash or beta
neutral, or both. Typically the portfolio will
exhibit a small or nil net market exposure.
Well-designed portfolios typically control for
industry, sector, market capitalization, and
other market factors. This translate to near
5050 balance to long and short positions.
Leverage is often applied to enhance
returns. Example A pair trade in a dual
listed company is a good example of an equity
market neutral strategy. This involves the
purchase of one share category and the sale of
another on the same stock. For example, the
manager Buys share in one class Company A,
Class C, listed in the UK Sells shares in
another class Company A, Class D, listed in
France Profit Opportunity The manager expects
class C stocks to rise in price and class D
stocks to fall based on some change to Company
As capital structure. There is no market or
sector risk as the two stocks are based on the
same economic entity, but happen to deviate in
price.