KCS
Fund Strategies Inc.
Disciplined Fund of Hedge Funds Portfolio Management
Contemporary Perspectives on Hedge Fund Investing
CFA Victoria – February 21st, 2007
Agenda
Why add hedge funds to a portfolio?
Why take a portfolio approach?
What are the merits of low volatility hedge funds?
Is an equity investing framework useful?
Page 2
What is a Hedge Fund?
Page 3
What is a Hedge Fund?
Description

Similar to mutual fund








Professionally managed pool of assets
Specified objectives
Investors typically must be qualified or
accredited
Short positions/hedging allowed
Leverage
Position concentration
Lower liquidity
Trading strategy ≠ investment strategy
Page 4
What is a Hedge Fund?
Hedge Fund Strategies
1.
2.
3.
4.
5.
6.
7.
Equity Long/Short
Equity Market Neutral
Dedicated Short Bias
Emerging Markets
Convertible Arbitrage
Fixed Income Arbitrage
Event Driven


8.
9.
10.
Merger Arbitrage
Distressed
Global Macro
Managed Futures / CTA
Multi-Strategy
Page 5
What is a Hedge Fund?
Typical Hedge Fund Trade
Hypothetical Convergence/Divergence Pairs Trade
110
Trade Initiated
Trade Initiated
Trade Completed
100
Trade Completed
Price
90
80
70
60
50
Asset 1
Asset 2
Page 6
What is a Hedge Fund?
Typical Hedge Fund Trading Model



A convergence hypothesis underlies the trading
model of most hedge fund managers
Trading models are analogous to business
models for private or public companies
Evaluation of likelihood of success is similar:



Focus on quality, track record of managers
Ensure strategy is well articulated
Look for sustainable competitive advantages
Page 7
Why add Hedge Funds to a Portfolio?
Page 8
Why add Hedge Funds to a Portfolio?
Stability of Returns & Outperformance
Growth of $100 since February 1997*
250
225
200
175
150
125
100
75
Feb-97
Feb-98
Feb-99
Tremont Index
Feb-00
HFR FoF Index
Feb-01
Feb-02
TSX Index
Feb-03
Feb-04
S&P 500 Index
Feb-05
Feb-06
Scotia Bond Index
Page 9
Why add Hedge Funds to a Portfolio?
High Return per Unit of Risk
CSFB/Tremont Indices vs. Traditional Assets – Since February 1997
20%
16.3%
15.2%
15%
9.8%
10%
Returns
9.0%
7.1%
7.2%
Standard
Deviation
5%
0%
Tremont Hedge Fund Index
S&P 500
TSX
Page 10
Why add Hedge Funds to a Portfolio?
Diversification Benefits
Correlations – Since February 1997
CSFB/Tremont
S&P 500
S&P 500
0.43
TSX
0.62
0.79
Scotia Bond Index
0.12
-0.02
TSX
0.05
Page 11
Why add Hedge Funds to a Portfolio?
Drawdown & Recovery

Drawdown


Period of negative returns from peak to trough
Hedge Fund Indices

Less severe and faster recovery
Other Metrics - Since February 1997
S&P 500
TSX
Scotia Bond Index
HFRI Conservative FoF Index (HFRI CFI)
CSFB/Tremont Index
%
Positive
Months
Maximum
Drawdown
Months to Recover
/ % Yet to Recover
60.5%
61.3%
69.7%
77.3%
71.4%
-46.28%
-45.05%
-11.19%
-6.62%
-13.81%
52 / 6.55%
38 / none
9 / none
6 / none
12 / none
Page 12
The Need for a Portfolio Approach
Page 13
Need for a Portfolio Approach
Benefits of Portfolio Approach
Annualized Standard Deviation of Various Equities
83.18%
90
80
70
55.59%
60
50
40
26.27%
30
16.40%
20
10
0
BCE
Nortel
Kinross
TSX
Page 14
Need for a Portfolio Approach
Benefits of Portfolio Approach
Annualized Standard Deviations of Hedge Funds
30%
25%
20%
13.72%
15%
12.44%
7.82%
10%
5.81%
5%
0%
10 Largest
Canadian
Hedge Funds
10 Largest
Global
Hedge Funds
CSFB/Tremont
Hedge Fund
Index
HFRI
Fund of Funds
Index
Page 15
Need for a Portfolio Approach
Risk of One Stock vs One Hedge Fund
BCE - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Representative Canadian Hedge Fund - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Page 16
Need for a Portfolio Approach
Risk of non-“Blue Chip” stocks
Nortel Networks Corp. - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
40%
50%
Kinross Gold Corp - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
Some extreme returns exceed scale and are lumped at +/- 50%
Page 17
Need for a Portfolio Approach
Risk of Hedge Fund Index vs Equity Index
S&P 500 Index - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Credit Suisse / Tremont Hedge Fund Index - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Page 18
Need for a Portfolio Approach
Risk of Hedge Fund Index vs Equity Index
TSX Index - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Scotia Capital Universe Bond Total Return Index - February 1997 to December 2006
40%
35%
30%
25%
20%
15%
10%
5%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Page 19
The Merits of Low Volatility
Hedge Funds
Page 20
Merits of Low Volatility Hedge Funds
Hedge Fund Strategy Risk Profiles
CSFB/Tremont Risk/Return - Since February 1997 - Annualized
20%
15%
10%
5%
11.9%
9.9%
2.7%
9.8%
3.6%
9.0%
5.4% 3.8%
4.8%
10.7%
9.4%
5.9%
12.4%
10.7%
11.9%
7.1%
17.8%
15.0%
9.6%
Tremont
Returns
Tremont Std
Deviation
0%
-1.5%
-5%
Equity Market
Neutral
Multi
Strategy
Fixed Income Convertible
Arbitrage
Arbitrage
Event
Driven
Global
Macro
Long / Short Managed
Emerging
Futures / CTA Markets
Equity
Dedicated
Short Bias
Hedge Fund Strategies to the left are less volatile and have higher return per
unit of risk (i.e. standard deviation).
Page 21
Merits of Low Volatility Hedge Funds
Hedge Fund Strategy Betas
CSFB/Tremont Strategy Betas vs. S&P 500 - Since February 1997
1.0
0.54
0.40
0.5
0.07
0.04
0.0
-0.01
0.04
0.21
0.10
-0.91
-0.13
-0.5
-1.0
Equity Market
Neutral
Multi
Strategy
Fixed Income Convertible
Arbitrage
Arbitrage
Event
Driven
Global
Macro
Long / Short
Managed
Equity
Futures / CTA
Emerging
Markets
Dedicated
Short Bias
Hedge Fund Strategies to the left have lower beta (i.e. sensitivity) to the S&P 500.
Page 22
Need for a Portfolio Approach
Best Diversification includes Global HFs


Globally $1.5 Trillion with 8,000 managers
Canada approx. $60 Billion with 70+ managers (Canada
Hedge Watch)
Scotia HF Index
CSFB/Tremont Index
27 Managers
Strategies
341 Managers
39 Funds
56 %
11 %
10 %
9 %
2 %
2 %
3 %
0 %
2 %
2 %
3 %
Equity L/S
Multi -Strategy
Market Neutral
Event Driven
Managed Futures
Fixed Income
Global Macro
Emerging Markets
Convertible Arbitrage
Dedicated Short Bias
Other
410 Funds
28 %
11 %
4 %
24 %
5 %
8 %
11 %
4 %
2 %
1 %
2 %
As of December, 2006
Page 23
Applying an
‘Equity Investing Framework’
to Hedge Funds
Page 24
Applying an ‘Equity Investing Framework’
U.S. Value Stock Selection Process
10,000+ US equities
Quantitative
Screens
‘Short list’
Bottom Up Analysis
Diversified Mutual Fund
Quantitative Screens
 Price-to-book
 Price-to-earnings
 Dividend-Yield
 Create ‘Short list’
Qualitative Analysis
 Bottom-up company review
 Core competencies and competitive
advantages
 Industry position
Diversified Portfolio
 Reduces risk
 Manager monitors holdings
Page 25
Applying an ‘Equity Investing Framework’
Hedge Fund Selection Process
8,000+ US and
International hedge funds
Quantitative
Screens
‘Short list’
Bottom Up Analysis
Diversified Portfolio of Hedge Funds
Quantitative Screens
 Understand drivers of returns
 Assessment of risks
 Consistency of results with stated
strategy
 Quantitative fit with overall portfolio
Qualitative Assessment
 Bottom-up manager review
 Core competencies and competitive
advantages
 Qualitative fit with overall portfolio
 Nature and extent of risk controls
Diversified Portfolio
 Reduces risk
 Manager monitors holdings
Page 26
Applying an ‘Equity Investing Framework’
Demands of Hedge Fund Investing

Successful hedge fund investing requires:





Expertise in analyzing trading strategies as businesses
Entry and exit discipline
Time commitment
Sufficient size of investment to allow diversification
 Need more than a single manager multi-strategy
Decide between:


Self manage
Outsource

Custom portfolio
 Funds of hedge funds

Combination
Page 27
KCS Approach
Page 28
KCS Approach
Investment Strategy

Based on





10 years Hedge Fund Investing experience
AIMA Award-winning Research
Proprietary Analytics
Focus on risk reduction
Objectives

Low volatility
 Low correlations with traditional assets
 Tax-preferred deferred capital gains
 ‘Equity-like’ returns with ‘bond-like’ volatility

Strategy

Levered low-volatility
Page 29
KCS Approach
HF Strategy Risk Profiles & the ACRF
CSFB/Tremont Weights vs. Current ACR Basket Weights
50%
40.8%
40%
29.6%
30%
20%
10%
Tremont
Weights
ACR Basket
Weights
23.1%
5.1%
11.3% 9.9%
11.9%
6.2% 11.2%
6.3% 10.9% 9.7%
5.1%
7.0%
0.0%
0.5% 0.0%
Long / Short Managed
Emerging
Futures / CTA Markets
Equity
Dedicated
Short Bias
2.5%
2.7%
0.0%
0%
Equity Market
Multi
Strategy
Fixed Income Convertible
Arbitrage
Arbitrage
Event
Driven
Global
Macro
CSFB/Tremont Risk vs. Current ACR Basket Risk - Annualized
20%
17.8%
15.0%
15%
10%
2.7%
5%
10.7%
9.4%
2.3%
3.6%
2.8%
3.8% 4.4%
5.9% 6.0%
4.8%
3.4%
2.1%
11.9%
Tremont
Std. Dev’n
ACR Basket
Std Dev’n
5.9%
0.0%
0.0%
0.0%
Long / Short Managed
Emerging
Equity
Futures / CTA Markets
Dedicated
Short Bias
0%
Equity Market
Neutral
Multi
Strategy
Fixed Income Convertible
Arbitrage
Arbitrage
Event
Driven
Global
Macro
Notes: Weights are as at December 30, 2006. All risk/return measures are since February, 1997, and have been annualized.
Page 30
Performance
+ 15.7% for 2006
Ranked #1 Fund of Funds in 2006 on
Canadian Hedge Watch
Page 31
KCS ACR Fund Performance
Fund Name for December
KCS Absolute Core Return Fund
Man Multi-Strategy (Canada) Fund Class F U$
Arrow Focus Fund Class F2
Arrow Global Long/Short Fund Class F
Arrow Multi-Strategy Fund Class G U$ Class F
Mac Alternative Strategies Class O
TA3 - Mesirow 'O' US$
Tremont Core Diversified Fund U$ Class O
Pro-Hedge Elite Fund Class F
TA3 - Safeguard US$
Pro-Hedge Capital Preservation Fund Class F
Arrow Enhanced Income Fund Class F
Pro-Hedge Capital Preservation PLUS Class F
TA3 - Hybrid 'F' C$
Quadrexx Market Neutral Performance Fund Series F
Pro-Hedge Capital Preservation USD Class A
Horizons Diversified Fund
Tremont Capital Opportunity Trust
Abria Diversified Arbitrage Trust Class O $US
Pescara Fund of Funds U$
Abria XL Trust Class O U$
HRS Absolute Return Trust
Stanton Diversified Strat LP - Class A C$ 151
Q1
10.56
Q2
0.067
Q3
-1.75
11.92
9.71
8.39
3.84
2.77
3.44
8.96
2.14
3.05
2.09
4.12
2.21
7.44
2.69
2.96
3.22
3.26
2.09
0.00
4.52
0.00
-3.68
-3.69
-0.69
-0.19
1.67
0.54
-4.9
1.03
0.27
1.71
-1.03
-1.65
-0.67
-0.08
-1.3
-1.38
3.36
1.03
-2.02
-1.38
-1.93
2.23
0.69
1.12
-3.25
0.04
0.48
-0.9
-0.78
-1.58
-2.75
0.16
-1.97
-3.2
0.67
-7.06
-0.42
0.42
1 Month 3 Months 6 Months
1.34
6.04
4.24
0.54
2.63
-6.22
2.24
6.28
4.13
2.33
7.3
5.82
2.23
5.53
3.49
2.26
5.02
7.36
1.7
3.9
4.61
1.45
3.86
5.03
1.32
4.8
3.94
1.48
3.24
3.28
0.29
1.29
1.77
1.12
2.45
1.95
0.1
1
0.22
3.42
5.74
4.08
0.49
0.47
-2.3
0.2
0.99
1.16
3.36
3.92
1.87
0.37
-1.09
-5.83
0.86
-6.02
-5.39
-9.1
-12.56
-18.74
3.06
1.82
3.67
-6.11
1.92
YTD
15.7
12.67
12.25
11.81
11.4
11.27
9.31
9.23
7.7
6.57
6.41
5.86
5.33
4.62
4.27
4.18
3.51
1.49
0.98
-16.19
-19.89
8.19
* For Internal Use Only - from www.canadianhedgewatch.com
Page 32
Questions and comments?
Page 33
This presentation is confidential. The contents are not to be reproduced or distributed to the public or the press.
Securities legislation may prohibit such distribution. This presentation is a summary only and should be used in
conjunction with the detailed information in the Confidential Offering Memorandum. The information contained in
this presentation is believed to be reliable, but is not guaranteed as to its accuracy or completeness. This
presentation is for information purposes only and does not constitute an offer to sell or a solicitation to buy the
securities referred to herein. No securities commission or similar regulatory authority has reviewed this document
or has in any way passed on the merits of the securities describe and any representation to the contrary is an
offence.
Historical performance is not a guarantee future results. KCS Fund Strategies Inc. recommends consulting
appropriate investment and financial advisors when considering any investment decision.
KCS Fund Strategies Inc.
2150 – 555 West Hastings Street
Vancouver, British Columbia
V6B 4N6
Ph: 604-730-0729 x 225
www.kcsfunds.com
Page 34