March 2010
Hedge Funds: Managing Tension Between Risk and Risk Management
Michael Stohler, Ph.D.
Chief Risk Officer, Alternative Investments, JPMorgan Private Bank
CONFIDENTIAL
CONFIDENTIAL
Investment Products:
- Not FDIC Insured
Please read important disclosures at the end of the presentation.
- No Bank Guarantee
- May Lose Value
Agenda
• Meta-risk evaluation: Primary risk management of hedge funds
– Historical analysis: Can history predict the future?
– Wearing two hats: Can a portfolio manager be his/her own risk manager?
– Data collection/computation vs. “real” risk management
– What does a robust risk monitoring program at a complex hedge fund look like?
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External evaluation of hedge fund managers
– What should an investor really worry about?
– So what can be done to avoid these risks?
– Monitoring exposures with limited transparency: Is it really worth all that work?
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– Striking a balance between quantitative and qualitative analysis
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Can history predict the future? Past performance is not indicative of future results
S&P 500 level and volatility bands (Feb 2008 – Dec 2009)
1800
1600
+2σ
S&P 500 level
1400
1200
+1σ
1000
-1σ
800
600
-2σ
400
200
Feb-08
Apr-08
Jun-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
Aug-09
Dec-09
Source: Bloomberg
Standard deviation1 is reflective of trailing 20 day S&P 500 returns
The S&P 500 fell below its first volatility band on September 15, 2008 (the Monday after the Lehman Brothers bankruptcy)
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Oct-09
Market movements as measured in standard deviations1 (S&P 500 trailing 20 day returns: Feb 2008 – Dec 2009)
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4
# of standard deviations
3
2
1
0
-1
-2
Lehman Bankruptcy
-4.14 standard deviations
-3
-4
-5
Feb-08
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Apr-08
Jun-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
As a result of the Lehman Bankruptcy, the S&P fell below four standard deviations1 of its average trailing 20 day return
Assuming a normal distribution, the probability of this occurring is .00006%
Aug-09
Oct-09
Dec-09
Source: Bloomberg
1Standard deviation measures the dispersion or uncertainty in a random variable (in this case, S&P daily returns). The higher the volatility of the investment returns, the higher will be the standard deviation. For this reason, standard deviation is often
measure of investment risk.
Past performance is no guarantee of future results.
used as a
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Garbage in, garbage out
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Financial markets are inherently non-normal in their return distributions
– Hedge funds (through leverage) can exaggerate this effect
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Tail events are notoriously difficult to predict and measure
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2008 demonstrates that VaR-based models are challenged without serious consideration of non-Gaussian distributions
Three basic flavors to account for non-Gaussian distributions are:
1. Make some guesses as to the other moments of the distribution
2. Historically sample (Monte Carlo style) out of a large data set
3. Utilize a heteroskedastic risk model
…all of which have issues
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While “stress testing” portfolios over various time periods (or via a factor-based approach) is often times the best one can do, 2008 demonstrated that reality
can sometimes be worse than your most draconian assumptions
Hedge funds performance clearly reflected the pressure on alternative assets
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Number of HFRI hedge fund indices with non-stressed performance1 (1990-2009)
Number of HFRI strategies
14
12
10
8
Liquidity crisis/ Massive
de-leveraging
6
4
2
0
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
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Source: PerTrac, Hedge Fund Research
1Chart is based on 14 HFRI strategy indices all with inception
dates of Jan 1990. Non-stressed performance is defined as trailing 3 month performance greater than - 4%. HFR Strategy indices included are: Equity Hedge, Equity Market Neutral, EH-Directional,
EH-Sector: Energy/Basic Materials, EH-Sector: Technology/Healthcare, Event Driven, Distressed/Restructuring, Merger Arbitrage, Macro, Relative Value, Short Bias, Emerging Markets, RV- Fixed Income Asset Backed, and RV-Fixed Income Convertible Arbitrage
Please refer to the back of this presentation for definitions of terms.
Past performance is no guarantee of future results.
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Indices are not investment products and may not be considered for investment.
Wearing two hats: Can a portfolio manager be his/her own risk manager?
Negatives
Positives
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Portfolio manager has direct exposure to holdings, research,
and daily firm activity
Full transparency in monitoring fund level positions and
leverage
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Difficulty with introspection
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Personal interests of the portfolio manager can interfere
with the interest of the fund’s limited partners (Free Option
Problem)
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Often times, this means investors have to accept very soft
limits on portfolio sizing and positioning. It therefore
becomes challenging to assess the potential risks the
manager may take
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Portfolio manager may not have time and energy to keep up
with best practices, technology, and infrastructure for risk
management
Total integration between decisions and risk management
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Key takeaway: Know what you ordered
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Data collection/computation vs. “real” risk management
As part of the due diligence process, a conversation with a Chief Risk Officer can give you clues as to how involved he/she
actually is with respect to the investment process
• Data collection/computation
– Passive method of managing risk
– Frequently outsourced
– Summarizes risk metrics and positioning with respect to
guidelines
– Results emailed/passively distributed to the investment team
• “Real” risk management
– Active method of managing risk/frequent dialogue
with portfolio manager(s)
– Look at both short-term and long-term risk
– Interprets information to help manage risk exposure,
investment decisions, and leverage
– Evaluates the risk of a fund from a investment and
operational level
– Risk officer has “teeth” and is able to impact risk
taking via the OMS, pulling capital, etc.
CENSORED –
ILLUSTRA-TION
ONLY
Investment A
Investment B
Investment C
Investment D
Investment E
Investment F
Investment G
Investment H
Investment I
Investment J
Investment K
Investment L
Investment M
Investment N
Investment O
Investment P
Investment Q
Investment R
Investment S
Investment T
Investment U
Investment V
Investment W
Investment X
As % Notional
Long
309.18%
Short
(308.60%)
Gross
617.78%
CONFIDENTIAL
VaR (% VaR)
Note: Tables shown are for illustrative purposes only
(2.49%)
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What does a robust risk monitoring program at a complex hedge fund look like?
• Ability to track the following and compare to existing guidelines
– Position sizing
– Geographical breakdown (net exposure, gross exposure,
VaR)
– Asset Class (net exposure, gross exposure, VaR)
– Issuer breakdown (net exposure, gross exposure, VaR)
– Sector (net exposure, gross exposure, VaR)
– Capitalization breakdown (net exposure, gross exposure,
VaR)
– Strategy breakdown (net exposure, gross exposure, VaR)
• Surface of sensitivities to most common price drivers (equities,
volatility, spreads, etc.)
• Portfolio (and sub-portfolio) level risk statistics such as VaR,
Omega, Vega, etc.
CONFIDENTIAL
• Some sort of factor analysis (macro, investible, both)
Key
takeaways:
Fund A Return
• Ability to benchmark performance (by sub-strategy)
Ask to see it
Get a good sense of who looks at it (and how often)
Please refer to the back of this presentation for definitions of terms.
Graph shown is for illustrative purposes only.
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Agenda
• Meta-risk evaluation: Primary risk management of hedge funds
– Historical analysis: Can history predict the future?
– Wearing two hats: Can a portfolio manager be his/her own risk manager?
– Data collection/computation vs. “Real” risk management
– What does a robust risk monitoring program at a complex hedge fund look like?
•
External evaluation of hedge fund managers
– What should an investor really worry about? (assuming the manager is good)
– So what can be done to avoid these risks?
– Monitoring exposures with limited transparency: Is it really worth all that work?
CONFIDENTIAL
– Striking a balance between quantitative and qualitative analysis
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What should an investor really worry about? (assuming the manager is good)
Serious Back Office Issues
CONFIDENTIAL
• Are the assets really there?
• Will the fund’s counterparties default debts or somehow
interrupt the normal course of business?
• Are the assets in the fund being fairly valued (when money
flows into and out of the fund)
• Is the manager’s financing going to remain in tact for the
foreseeable future?
Serious Front Office Issues
• Does the investor really understand the strategy? (i.e.
know what a tail event might look like)
• Manager drifts from historical/understood style and risk
taking
• Will the investor be able to redeem when he/she needs to?
• Manager starts to focus on something else aside from the
portfolio (fund raising, divorce, golf, etc.)
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Thoughtful consideration of a few key areas can make a big difference
Are your assets safe?
Are there any hidden counterparty exposures?
Custody
Prime Brokers
• Understanding the implications of service agreements,
leverage and possible re-hypothecation
• How many prime brokerage relationships does the fund
have? Are they with reputable institutions?
• Prime broker protection: provided under 15c3-3
• What leverage is available to a fund through each prime?
Under what terms?
• Benefits and costs associated with trust environments
• Challenges of the global custody model
• The “custody” of non-securities (off the DTCC Grid):
confirmation of counterparties
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• Understanding the role the fund’s administrator and
auditor with respect to asset confirmation
• What are the prime brokers’ procedures around
reconciliation of trades?
• In which country does the prime broker custody the
fund’s assets and to what degree can these assets be rehypothecated?
• Who are the authorized signatories for the fund? How
many signatures are required to move cash from the
fund?
*Rule 15c3-3 is the SEC customer protection rule. It requires a broker dealer to establish a special reserve account for the protection of its customers and also requires a broker / dealer to have custody or control of
certain customer securities.
Please refer to the back of this presentation for definitions of terms.
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Additional oversight and controls are vital to operational best practice
Are the returns real?
Valuation, Administration & Audit
Valuation:
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Transparency and consistency of internal oversight/reconciliation policies and procedures
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Quality of 3rd party pricing and administration around the valuation of illiquid assets
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Reasonability of valuation given types of securities
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Valuation committee dynamics/process oversight
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Quality of documentation provided to the administrator on “fair value” assets
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Incentives structure of those associated with the valuation process
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Impact of FAS 157*
Administration:
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Does the fund self-administer?
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What are the administrator’s procedures for reconciling trades and assets?
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How often is the portfolio valued? Daily, weekly, monthly?
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What is the process for calculating NAV?
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What is the valuation methodology for illiquid investments? Is a 3rd party consultant used?
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Does the fund keep its own books and records in addition to having an external administrator?
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Audit:
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Does the fund have a reputable auditor?
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What information does the auditor get directly from the fund vs. the administrator and prime brokers?
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To what degree does the auditor review pricing policies?
*Note: FAS 157/157-g is governed by the Financial Accounting Securities Board and its intention is for fair valuation of assets.
Please refer to the back of this presentation for definitions of terms.
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Front office risks can also be avoided…
…Via monthly manager calls, on-site manager visits and proprietary quantitative analysis, a due diligence team can proactively:
• Analyzes markets, exposures, fund and manager behavior on an intra-month basis
• Conducts factor-based analysis to evaluate manager and style, as well as confirm information released by a fund
• Monitors exposure to a single fund, family of funds, strategy, style
• Dynamically assesses potential portfolio losses and cross-portfolio exposures; monitors portfolio limits
• Discusses with managers any changes in themes, strategy, underlying portfolio, and challenges their assumptions
• Conducts operational due diligence to evaluate and monitor risk management process, counter-party exposure and financing terms
• Evaluating a fund’s financing lines and access to capital to better understand the fund’s ability to withstand market stress
• Understand portfolio liquidity
Frequency
Daily
CONFIDENTIAL
Mid-month
Suggested monitoring activity
Review and analyze manager returns where available, review relevant news articles and filings
Review and analyze mid-month performance estimates and monthly results
Monthly
Conduct monthly due diligence calls
Monthly
Quantitative analysis conducted to assess risk/return drivers
Monthly
Assess risk/return drivers, portfolio composition, changes, outlook, etc.; decompose alpha/beta
Monthly
Review risk reports and other fund commentary
Ongoing
Conduct peer group analysis
Ongoing
Direct contact with managers as needed (e.g. in times of market stress or key events)
Ongoing
Conduct face-to-face meetings
Annually
Review financial statements and regulatory filings
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Monitoring exposures with limited transparency: Is it really worth all that work?
What’s so hard about this?
– Various channels and sources of information (risk reports, verbal
conversations with fund managers, 13F filings, 3rd party services, etc.)
– Varying definitions of statistics that managers utilize
• Gross exposure
• Notional exposure
• Market value exposure
• 10 year equivalent
• VaR1
– No automated data feeds
• Manual data input may lead to human error
• Time consuming
What does one get?
– Ability to aggregate exposure to strategies and asset classes
– Real ability to judge manager style and beta orientation
– Check and balance system for internal risk guidelines
– Means to verify statements made by managers
– Means to glean the collective wisdom of a large number of
effective hedge fund managers
Performance differences between funds may result from differing amounts of leverage and net exposure. If not handled correctly, it’s easy to draw inaccurate
conclusions
Cumulative return of Fund A and Fund B: Nov 2006 to Aug 2009
35%
Fund A
30%
25%
Fund B
Cumulative return of Fund A and Fund B: Nov 2006 to Aug 2009
Leverage: Fund A has outperformed Fund B over time, but Fund
A is levered 4 to 1 while Fund B uses little to no leverage
40%
35%
30%
20%
15%
Fund B
Return
Return
25%
20%
15%
10%
5%
Source: JPMorgan
Jul-09
Apr-09
Jan-09
Oct-08
Jul-08
Apr-08
Jan-08
Oct-07
Jul-07
0%
-5%
-10%
Apr-07
Aug-09
May-09
Feb-09
Nov-08
Aug-08
May-08
Feb-08
Nov-07
Aug-07
May-07
Feb-07
Nov-06
-10%
-15%
Jan-07
0%
-5%
Oct-06
10%
5%
CONFIDENTIAL
Removing the leverage component of Fund A’s return allows us to see that
Fund B has actually outperformed Fund A on an unlevered basis
Fund A
Source: JPMorgan
1Value at Risk (VaR) is a widely used risk measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the
probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.
Charts shown are for illustrative purposes only
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Striking a balance between quantitative and qualitative analysis: Both are needed to create a robust due diligence engine
Fund X’s July 2009 strategy attribution
Quantitative support is a critical input into decision making
International Equity
Statistical Arbitrage
0.8%
US Equity
0.9%
1.0%
European Equity
Relative Value/Credit
0.0%
Special Opportunities
0.0%
Macro
0.1%
Private Investments
0.1%
Fixed Income
Other
•
2.1%
•
0.3%
0.0%
Determining and assessing contributors of return:
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Which exposures are driving returns?
–
Are we comfortable with the exposure and/or contribution from
them?
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Expected or accidental returns?
Assessing risk components of return:
–
Which exposures are contributing to risk?
–
Frequency? How quickly are managers trading in and out of these
exposures?
5.2%
Fund X
0%
1%
2%
3%
4%
5%
6%
Source: JPMorgan
Cumulative attribution from longs and shorts: Manager Z
Source: JPMorgan
Cumulative attribution - Longs
May-09
May-08
May-07
May-06
Cumulative attribution - Shorts
May-05
2Q09
Other
180%
160%
140%
120%
100%
80%
60%
40%
20%
0%
-20%
-40%
May-04
0.2%
-0.5%
-1.5%
Asia
1Q09
Europe
0.7%
0.1%
0.2%
6.3%
4Q08
3Q08
-11.1%
-0.4%
-0.3%
-0.3%
-0.6%
-1.8%
-0.2%
-0.6%
-0.2%
0.2%
0.6%
1.3%
United States
2Q08
1Q08
CONFIDENTIAL
-3.8%
0.4%
0.0%
4.3%
5.1%
Quarterly gross geographic attribution for Manager Y
Source: JPMorgan
Charts shown are for illustrative purposes only.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
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Qualitative analysis sits at the core of the investment due diligence process
Background:
Resources:
• Experience and integrity of key investment
professionals is essential
• Proper staffing to support stated investment
process
• Background checks on key principals
• Adequate systems and analytical tools
• Direct conversations with portfolio managers and
investment support staff
• References from other investors and previous
employers and portfolio managers at competitor funds
• Ability to attract and retain top industry talent
Background
Resources
• Ability of fund & firm AUM and fees to
support resources
• Recognized third party service providers
• Input from relevant industry contacts
Risk
Controls
Communication
Communication:
Risk Controls:
• Holistic portfolio oversight in terms of overall risk
exposure monitoring and tail risk analysis
• Adequate systems and data management to support
risk monitoring needs
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• Pre-trade compliance/controls
• Comfortable sharing portfolio details:
AUM, exposures, attributions, top
positions, etc.
• Free flow of information about upcoming
investment opportunities or changes in
strategy
• Providing necessary transparency
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Definitions of terms
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An Administrator provide a variety of services including: accounting of contributions and withdrawals, computing profits and losses, transfer agent services (handling sub docs & wires), calculating management and performance fees, may act as the registered
agent and registrar (offshore), and AML review. While many hedge funds use 3rd party administration services, some chose to self-administer.
Alpha: A measure of the difference between a portfolio’s actual returns and its expected performance.
An annualized return is an investment return, discounted retroactively from a cumulative figure, at which money, compounded annually, would reach the cumulative total.
An Auditor works closely with the administrator (who prepares a fund’s financial statements) to review: the valuation methodology as well as the implementation of that methodology, the fund’s account statements including the profits and losses, and the
annual financial statements which should result in an opinion attached to the financials.
Autocorrelation is the cross-correlation of a set of fund returns with itself. Informally, it is the similarity between returns as a function of the time separation between them. It is a mathematical tool for finding repeating patterns.
Beta: The ratio of a dependent variable’s volatility to an independent variable’s volatility.
A Custodian is ultimately the only entity that can verify the existence of securities with 100% certainty. Custodians do not custody non-securities (derivatives, loans, trade claims, etc.). Both the administrator and the fund typically confirm trades, assets and cash
balances with custodians on a regular basis.
Correlation is a statistical measure of the degree to which the movements of two variables are randomly related. Correlation can range from -1.0 to 1.0 with 1.0 indicating a perfect positive correlation and -1.0 indicating a perfect negative correlation.
Heteroskedastic is an adjective describing a sequence of variables in which each variable has a different variance. Heteroskedastics may be used to measure the margin of the error between predicted and actual data.
Maximum drawdown is the maximum peak to trough decline during a specific record period of an investment or fund. It is usually quoted as the percentage between the peak to the trough.
A Monte Carlo simulation is a computer simulation that seeks to determine the likelihood of various scenarios by running multiple simulations using random variables. The results of the Monte Carlo simulation show the most likely outcomes.
A Non-Gaussian distribution is another term used to define a non-normal distribution.
A Prime Broker can provide a number of services for hedge funds including: trading and execution, custodial and settlement services , leverage and margin, short sales, access to IPOs, consulting services, capital introduction, reporting to administrator or
investors, soft dollars, office space and IT support, & stress test analysis and other portfolio monitoring.
P Value is the level of marginal significance within a statistical hypothesis test, representing the probability of the occurrence of a given event. The smaller the p-value, the stronger the evidence is in favor of the alternative hypothesis.
R-Squared: A measure that represents the percentage of a fund’s or security’s movements that are explained by movements in a benchmark index. R-squared values fall between 0 and 1, where 0 indicates no correlation and 1 indicates perfect correlation.
Regression: A statistical technique that finds the optimal relationship between a predictor and a response.
Multiple Regression: Regression with two or more predictors (independent variables) and one response (dependent variable).
The Sharpe ratio is a return/risk measure, where the return (the numerator) is defined as the incremental average monthly return of an investment over the risk free rate. Risk (the denominator) is defined as the standard deviation of the monthly investment
returns less the risk free rate. A risk free rate of 4% was used to calculate the Sharpe ratio. Values are presented in annualized terms; annualized Sharpe ratios are calculated by multiplying the monthly Sharpe ratio by the square root of twelve.
Skew is a measure of the asymmetry of the probability distribution of a real-valued random variable.
Standard deviation measures the dispersion or uncertainty in a random variable (in this case, investment returns.) It measures the degree of variation (in this case) of monthly net returns around the average monthly net return. The higher the volatility of the
investment returns, the higher will be the standard deviation. For this reason, standard deviation is often used as a measure of investment risk.
Omega: The probability of experiencing a return over a specified return divided by the probability of experiencing a return under that same specified return.
Tracking Error: A measure of how closely a manager’s returns track the returns of a benchmark. It is the standard deviation of excess returns over a benchmark.
Univariate refers to an equation or function of only one variable. The term is commonly used in statistics to distinguish a distribution of one variable from a distribution of several variables, although it can be applied in other ways as well.
Up-Market / Down-Market Capture: A measure of the extent to which the portfolio or vehicle participates in positive/negative market performance. A number more than 100 signifies greater participation. A number less than 100 signifies less participation.
Variance: The square of standard deviation.
Value at Risk (VaR) is a widely used risk measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the
portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.
Vega: The measure of change in an option value given the change in the volatility.
Volatility - As measured by standard deviation is a measure of return dispersion. To estimate this dispersion it is necessary to have a representative sample of observations.
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Definitions of indices
CONFIDENTIAL
All index performance information has been obtained from third parties and should not be relied upon as being complete or accurate. Indices are shown for comparison purposes only. They are not investment products available for purchase. Indices are
unmanaged and generally do not take into account fees or expenses or employ special investment techniques such as leveraging or short selling. Furthermore, while some hedge fund indices may provide useful indications of the general performance
of the hedge fund industry or particular hedge fund strategies, all hedge fund indices are subject to selection, valuation, survivorship and entry biases, and lack transparency with respect to their proprietary computations.
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A Benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose.
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The S&P 500 Index (“S&P 500”) consists of 500 stocks chosen for market size, liquidity and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate
to its market value. All returns include reinvested dividends except where indicated otherwise. The S&P Total Return Index also includes dividends reinvested.
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The Barclays Aggregate Bond Index represents securities that are U.S. domestic, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage
pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. This index was formerly the Lehman Aggregate Bond Index
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The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. The MSCI World Index consists of the following 23 developed market country indices: Australia, Austria,
Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States.
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The J.P. Morgan Global High Yield Index is designed to mirror the investible universe of the US$ global high yield corporate debt market including domestic and international issues. CSSWHYI is the Bloomberg ticker. It is not possible to invest directly in an
index.
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HFRI Event Driven Index: Investment Managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder
buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure
includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis
predicated on a specific development exogenous to the existing capital structure.
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HFRI Equity Hedge Index - Equity Hedge investing consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and
commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 index and put spreads.
Conservative funds mitigate market risk by maintaining market exposure from zero to 100 percent. Aggressive funds may magnify market risk by exceeding 100 percent exposure and, in some instances, maintain a short exposure. In addition to equities, some
funds may have limited assets invested in other types of securities.
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HFRI Macro Index: Investment Managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity
markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies
employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a
similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the
fundamental characteristics on the company are the most significant are integral to investment thesis.
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HFRI Relative Value Index: Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and
quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between
instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed
to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.
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HFRX Convertible Arbitrage Index - Convertible Arbitrage involves taking long positions in convertible securities and hedging those positions by selling short the underlying common stock. A manager will, in an effort to capitalize on relative pricing
inefficiencies, purchase long positions in convertible securities, generally convertible bonds, convertible preferred stock or warrants, and hedge a portion of the equity risk by selling short the underlying common stock. Timing may be linked to a specific event
relative to the underlying company, or a belief that a relative mispricing exists between the corresponding securities. Convertible securities and warrants are priced as a function of the price of the underlying stock, expected future volatility of returns, risk free
interest rates, call provisions, supply and demand for specific issues and, in the case of convertible bonds, the issue-specific corporate/Treasury yield spread. Thus, there is ample room for relative misvaluations.
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HFRI Fund Weighted Composite Index – Includes both domestic and offshore funds. The index is equal-weighted and does not include fund of funds. All funds report assets in USD. All funds report net of all fees. Returns of all funds are reported on a monthly
basis. All funds have at least $50 million under management or have been actively trading for at least twelve (12) months.
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Key risks of investing in alternatives
General/Loss of capital. An investment in alternative investment funds involves a high degree of risk. There can be no assurance that the alternative investment fund’s return objectives will be realized and investors in the alternative
investment fund could lose up to the full amount of their invested capital. The alternative investment fund’s fees and expenses may offset the alternative investment fund’s trading profits.
Lack of information. The industry is largely unregistered and loosely regulated with little or no public market coverage. Investors are reliant on the manager for the availability, quality and quantity of information. Information regarding
investment strategies and performance may not be readily available to investors.
Limited liquidity. Interests are not publicly listed or traded on an exchange or automated quotation system. There is not a secondary market for interests, and as a result, invested capital is less accessible than that of traditional asset
classes. Also, withdrawals and transfers are generally restricted.
Dependence on Trading Manager. Performance is more dependent on manager-specific skills, rather than broad exposure to a particular market.
Event risk. Given their niche specialization, market dislocations can affect some strategies more adversely than others.
Speculation. Alternative investments often employ leverage, sometimes at significant levels, to enhance potential returns. Investment techniques may include the use of derivative instruments such as futures, options and short sales,
which amplify the possibilities for both profits and losses and may add volatility to the alternative investment fund’s performance.
Potential conflicts of interest. The payment of a performance based fee to the Trading Manager may create an incentive for the Trading Manager to cause the alternative investment fund to make riskier or more speculative investments
than it would in the absence of such incentive.
Valuation. Because of overall size or concentration in particular markets of positions held by the alternative investment fund or other reasons, the value at which its investments can be liquidated may differ, sometimes significantly, from
the interim valuations arrived at by the alternative investment fund.
Leverage. The capital structures of many financial services companies typically include substantial leverage. In addition, investments may be consummated through the use of significant leverage. Leveraged capital structures and the use
of leverage in financing investments increase the exposure of a company to adverse economic factors such as rising interest rates, downturns in the economy or deteriorations in the condition of the company or its industry and make the
company more sensitive to declines in revenues and to increases in expenses.
Currency risks and Non-United States investments. Investments may be denominated in non-U.S. currencies. Accordingly, changes in currency exchange rates, costs of conversion and exchange control regulations may adversely
affect the dollar value of investments.
Financial services industry risk factors. Financial services institutions have asset and liability structures that are essentially monetary in nature and are directly affected by many factors, including domestic and international economic
and political conditions, broad trends in business and finance, legislation and regulation affecting the national and international business and financial communities, monetary and fiscal policies, interest rates, inflation, currency values,
market conditions, the availability and cost of short-term or long-term funding and capital, the credit capacity or perceived creditworthiness of customers and counterparties, and the volatility of trading markets. Financial services
institutions operate in a highly regulated environment and are subject to extensive legal and regulatory restrictions and limitations and to supervision, examination and enforcement by regulatory authorities. Failure to comply with any of
these laws, rules or regulations, some of which are subject to interpretation and may be subject to change, could result in a variety of adverse consequences, including civil penalties, fines, suspension or expulsion, and termination of
deposit insurance, which may have material adverse effects.
CONFIDENTIAL
Risks associated with infrastructure investments generally. An infrastructure investment is subject to certain risks associated with the ownership of infrastructure and infrastructure-related assets in general, including: the burdens of
ownership of infrastructure assets; local, national and international economic conditions; the supply and demand for services from and access to infrastructure; the financial condition of users and suppliers of infrastructure assets;
changes in interest rates and the availability of funds which may render the purchase, sale or refinancing of infrastructure assets difficult or impracticable; changes in environmental laws and regulations, and planning laws and other
governmental rules; environmental claims arising in respect of infrastructure assets acquired with undisclosed or unknown environmental problems or as to which inadequate reserves have been established; changes in the price of
energy, raw materials and labor; changes in fiscal and monetary policies; negative developments in the economy that depress travel; uninsured casualties; force majeure acts, terrorist events, under-insured or uninsurable losses; sovereign
and sub-sovereign risks; contract counterparty default risk.
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Important information
IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any
discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used,
and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated
with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. taxrelated penalties.
Each recipient of this presentation, and each agent thereof, may disclose to any person, without limitation, the U.S. income
and franchise tax treatment and tax structure of the transactions described herein and may disclose all materials of any kind
(including opinions or other tax analyses) provided to each recipient insofar as the materials relate to a U.S. income or
franchise tax strategy provided to such recipient by JPMorgan Chase & Co. and its subsidiaries.
Bank products and services are offered by JPMorgan Chase Bank, N.A. and its affiliates. Securities products and services are
offered by J.P. Morgan Securities Inc., member NYSE, FINRA and SIPC.
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan
Securities Inc. or its brokerage affiliates may hold a position or act as market maker in the financial instruments of any issuer
discussed herein or act as an underwriter, placement agent, advisor or lender to such issuer. The views and strategies
described herein may not be suitable for all investors. The discussion of loans or other extensions of credit in this material is
for illustrative purposes only. No commitment to lend by J.P. Morgan should be construed or implied. This material is
distributed with the understanding that we are not rendering accounting, legal or tax advice. Estate planning requires legal
assistance. You should consult with your independent advisors concerning such matters.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions,
estimates, and investment strategies and views expressed in this document constitute our judgment based on current market
conditions and are subject to change without notice. This material should not be regarded as research or a J.P. Morgan
research report. Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan, including
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contexts by other J.P. Morgan market strategists.
J.P. Morgan Securities Inc. may act as a market maker in markets relevant to structured products or option products and may
engage in hedging or other operations in such markets relevant to its structured products or options exposures. Structured
products and options are not insured by the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board, or any
other governmental agency.
In discussion of options and other strategies, results and risks are based solely on hypothetical examples cited; actual results
and risks will vary depending on specific circumstances. Investors are urged to consider carefully whether option or optionrelated products in general, as well as the products or strategies discussed herein are suitable to their needs. In actual
transactions, the client’s counterparty for OTC derivatives applications is JPMorgan Chase Bank, N.A., London branch. For a
copy of the “Characteristics and Risks of Standardized Options” booklet, please contact your J.P. Morgan Advisor.
Real estate, hedge funds, and other private investments may not be suitable for all individual investors, may present significant
risks, and may be sold or redeemed at more or less than the original amount invested. Private investments are offered only by
offering memoranda, which more fully describe the possible risks. There are no assurances that the stated investment
objectives of any investment product will be met. Hedge funds (or funds of hedge funds): often engage in leveraging and other
speculative investment practices that may increase the risk of investment loss; can be highly illiquid; are not required to
provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing
important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees.
Further, any number of conflicts of interest may exist in the context of the management and/or operation of any hedge fund.
JPMorgan Funds are distributed by JPMorgan Distribution Services, Inc., which is an affiliate of JPMorgan Chase & Co. Affiliates
of JPMorgan Chase & Co. receive fees for providing various services to the funds. Call JPMorgan Distribution Services at 1-800480-4111 or visit www.jpmorganfunds.com for the prospectus. Investors should carefully consider the investment objectives,
risks, charges and expenses of the mutual funds before investing. The prospectus contains this and other information about
the mutual fund and should be read carefully before investing.
As applicable, portions of mutual fund performance information may be provided by Lipper, a Reuters company, subject to the
following: © 2008 Reuters. All rights reserved. Any copying, republication or redistribution of Lipper content, including by
caching, framing or similar means, is expressly prohibited without the prior written consent of Lipper. Lipper shall not be liable
for any errors or delays in the content, or for any actions taken in reliance thereon.
Past performance is no guarantee of future results.
Additional information is available upon request.
CONFIDENTIAL
© 2010 JPMorgan Chase & Co.
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