Fund of Hedge Funds Program

Quarter 2009
Hedge Fund Industry White Paper

November 16, 2009

Eric Attias
Chief Investment Officer

CONFIDENTIAL
Following the financial debacle of 2008, we are welcoming a new era that we believe will be very
conducive to hedge fund investing. Prior to 2008, many investors were overly focused on
performance, and eventually discovered that they had made compromises with regard to liquidity,
transparency and risk management. Investor awareness to the importance of these factors was
heightened in the aftermath of 2008, with many hedge funds and funds of hedge funds mired in
negative performance, liquidity problems and manager frauds. Investors are now driving demand for
better alignment with managers on these issues, but it is important for investors to recognize the
possible trade-off these requirements have versus the potential for Alpha generation. A few fund of
hedge fund managers have shown that it is possible to create a portfolio of hedge funds within a strong
risk management framework that also satisfies most investors' needs for transparency and liquidity,
while maintaining strong Alpha generation. In addition, hedge fund managers and regulatory bodies
have responded with initiatives geared towards reform.
The purpose of this paper is to analyze the current hedge fund industry and the regulatory
developments that may enable investors to capitalize on hedge fund Alpha generation without
compromising on transparency, liquidity, fraud risk and the other issues that have recently plagued the
industry.

• We are now welcoming a new era that should be very conducive to hedge fund
investing
• Investors are driving demand for an increase in transparency, liquidity and
minimization of fraud risk, having accepted compromises prior to 2008
• Regulatory bodies have responded with initiatives geared towards reform
• Hedge fund industry and regulatory developments may enable investors to better
capitalize on hedge fund Alpha generation

Performance
There are signs that the worst is over and that an economic recovery may already be underway. We
remain cautious, however, and believe that we will continue in a low growth environment for the
foreseeable future until there is a sustained improvement in unemployment levels, housing market
valuations and “real” household disposable income.
Economic data in the US has been steadily improving, and for the most part beating expectations,
despite remaining relatively weak. Similar to the period immediately following the previous credit
crisis in 2002 (which may be considered to have ended in March of 2003,) the next two to three years
should provide tremendous opportunities for Alpha generation. Looking at the 36-month rolling
performance of the HFRI Fund Weighted Composite Index (see graph below), it indicates that peak
performance was reached three years after March 2003.

Source: Hedge Fund Research.

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During the last full economic cycle (March ’03–March ’09 or March ’03–June ’09 depending on the
economist’s view to which you subscribe), hedge funds generally outperformed other traditional broad
market indices with a higher Sharpe Ratio, as measured by the HFRI index.
Merrill Lynch HFRI Fund
Annualized Return / S&P 500 TR Barclays US Treasury Total High Yield US Weighted
Sharpe Ratio Index Return Index (7-10 yr) Master II TR 1-M Libor Composite
Index Index
From Mar-03 to Mar-09 1.10% / -0.14 5.85% / 0.37 3.53% / 0.03 3.17% 6.02% / 0.43
From Mar-03 to Jun-09 3.44% / 0.03 4.75% / 0.23 6.85% / 0.32 3.06% 7.26% / 0.61
Sources: Hedge Fund Research, Bloomberg, iShares

The macroeconomic climate and market conditions for hedge fund investing may be better now than
after other recent bear markets. Major world economies are emerging from the crisis while
governments continue to provide excess liquidity to the financial system. New G-20 cooperation and
regulatory reforms should reassure investors and result in additional market stability. Over the course
of the next several months, credit spreads should stabilize and perhaps inch higher, while equities
should correct from the current rally or at best remain within a trading range. Volatility of asset
classes should remain at relatively low levels with the VIX trading below or around 30. This implies a
greater emphasis on the dispersion among equities and corporate credit, providing hedge fund
managers with strong opportunities for Alpha creation. Historically, market environments with a
declining VIX or a VIX trading between 15 and 30, have been very favorable for hedge fund Alpha
generation (see graph below). Going forward, both credit and equities should offer attractive trading
opportunities as the dispersion of values increases.

Sources: Hedge Fund Research and Bloomberg.

We believe the current macroeconomic climate and market conditions for hedge
fund investing may be better now than after other recent bear markets

Despite our relative optimism, we are mindful of alternate scenarios going forward, although we
consider them lower probabilities. The first scenario is a V-shaped economic recovery, which would
favor Beta-oriented managers, as low-Beta hedge fund managers focused on Alpha generation will
underperform the equity markets. While government and regulatory intervention have reduced the
likelihood of another systemic shock to the financial system, another scenario would be a second
contraction of market liquidity and significantly increased volatility. If either of these scenarios
occurred, we believe that hedge fund managers would be better positioned than they were prior to the
2008 crisis. Given the lessons learned over the last twelve months, hedge funds are generally less
levered and are invested in more liquid assets.

Industry Consolidation
Major shifts in the industry have brought consolidation among participants, as it is imperative to have
critical mass in assets under management to maintain an acceptable level of operational infrastructure

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and to retain the talented personnel needed to generate performance. According to Hedge Fund
Research’s (“HFR’s”) third quarter 2009 industry report, approximately 21% of the hedge funds and
fund of hedge funds operating at the end of 2007 have since been liquidated, and it is expected that this
trend will continue. Many of the best performing or largest hedge funds have taken this opportunity to
attract talent made available by headcount reductions at investment banks and underperforming hedge
funds. Given the misalignment of incentives and performance at many banks, top traders are now
moving to hedge funds that are able to adequately compensate them. Millennium, Citadel, Brevan
Howard and SAC are among funds that have reportedly hired new talent in 2009. As a whole, the
hedge fund industry, with a fewer number of participants, should be well positioned to redistribute and
integrate its most talented professionals and deliver strong Alpha in the future.

Investor Transparency
The market turbulence experienced last year, and then the Madoff fraud, has resulted in investors
demanding greater transparency from hedge fund managers. In response to this outcry, a growing
number of hedge fund managers have begun to provide investor transparency via independent risk
aggregators such as Measurisk and RiskMetrics, as well as through fund administration and managed
account platforms. According to RiskMetrics, for example, the number of managers utilizing their
platform to provide investors with independent risk and exposure information increased by
approximately 80% over the last twelve months. While balancing the confidentiality needs of
managers, such platforms function as intermediaries between hedge fund managers and investors and
enable investors to obtain the information necessary to assess risk exposure. The table below shows
the percentage of funds in Nexar’s Investable Universe 1 utilizing third party platforms in this way.
“Risk Transparency,” as opposed to position level transparency, provides key summary risk and
exposure statistics allowing investors to understand their exposure to major factors like aggregate
leverage, position concentration, sector concentration and liquidity risk.
Nexar’s Investable Independent Independent Independent Independent Risk
Universe Custodian Administration Prime Broker Transparency

September 2008 100% 87% 100% Less than 50%

September 2009 100% 100% 100% 70% +

Additionally, industry initiatives, such as the Investors’ Committee to the President’s Working Group
on Financial Markets, continue to play a role in articulating the transparency needs of investors and
providing guidelines for hedge fund managers to enhance the frequency and quality of risk
information. To the extent that they result in increased transparency, developing regulatory changes -
both in the US and the European Union - can reinforce the positive trends already underway.

Leverage
Evidence suggests that the significant deleveraging that occurred among hedge funds last year has
largely abated, and many prime brokerage firms are again interested in expanding the range of services
provided to hedge funds, particularly those that successfully navigated the events of 2008. Morgan
Stanley, for example, recently reported in connection with its third quarter earnings release that it has
recaptured some of the prime brokerage market share that it lost during the fourth quarter of 2008
when clients were withdrawing cash balances and reallocating positions to other firms.

1
Nexar’s Investable Universe represents a statistically robust sample (30+ funds) that are approved by
Nexar and open for investment. The strategy breakdown of funds in the sample is: Equity Hedge
(20.0%); Global Macro/CTA (28.6%); Relative Value (51.4%).

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The charts above illustrate the estimated average gross and net exposure among Equity Hedge and
Relative Value funds in Nexar’s Investable Universe before, during and after the Lehman Brothers
bankruptcy. Despite the greater availability of credit and increased use of leverage relative to year-end
2008 levels, hedge fund managers are now generally more cautious in their use of leverage. They are
also cognizant of the potential business risk resulting from concentrating prime brokerage balances
with one or two firms. For example, while few hedge funds employed multiple prime brokers prior to
the 2008 crisis, we are increasingly seeing hedge fund managers systematically diversifying prime
broker and counterparty exposure and formalizing procedures to monitor the creditworthiness of their
counterparties.

Investment Horizon
In addition to the liquidity of the underlying portfolio investments, investors should also analyze the
investment horizon of the fund’s strategy and make certain it matches their own. The fund of hedge
funds investor should consider their investment horizon to be that of the longest underlying hedge fund
investment in their portfolio, and not the average duration. Short-term investors should focus more on
high portfolio turnover/high-frequency “trading” strategies that are likely to be able to deliver their
required liquidity regardless of the market environment. Whereas more static/fundamental
“investment” strategies are generally more suitable for investors with a longer investment time horizon
who are less sensitive to the liquidity of the underlying instruments in which they invest. For example,
a high-frequency equity trader may be better suited to a short-term investor than a fundamental
long/short equity manager. Both managers may hold the same underlying instruments, but the
strategies (trading vs. investment), and thus the portfolio turnover, are very different. The first strategy
versus the latter generally has a lower performance profile, volatility, and correlation to the equity
indices and is closer to the classic idea of an absolute return investment. However, trade-offs between
performance and the volatility of the hedge fund portfolio is another factor that bears consideration.
Liquidity
• Private Equity

Illiquid

• Distressed

Less liquid
• Credit / High Yield

• Activists

• Event Driven
Liquid
• Long/Short Equity/Long Bias
• Global Macro

• High Frequency Strategies

• Statistical Arbitrage
Very liquid
• CTA Short-Term • CTA Long-Term

Strategy Investment Horizon

An investor’s time horizon must be aligned with the time horizon of the
investment strategy

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Liquidity Alignment
One of the major hedge fund industry flaws highlighted by last year’s turmoil was the mismatch
between the liquidity terms offered by funds of hedge funds and the liquidity of the underlying hedge
fund investments. Commingled funds of hedge funds generally provided investors with monthly or
quarterly redemption rights, yet failed to keep pace with the changing, less liquid profile of many
underlying hedge fund managers’ portfolios. As a result, many funds of hedge fund investors were
surprised when the funds of hedge funds imposed gates or created side pockets in response to
redemption restrictions being imposed by the underlying managers.
The liquidity of a fund of hedge funds portfolio is not the average liquidity of the underlying hedge
funds, as was the common view in the past, and it should never be more frequent than the liquidity
provided by any of the underlying hedge funds. Additionally, the liquidity provided by the underlying
managers has to be carefully evaluated in the context of the assets in which the manager invests in both
normal and stressed market conditions. It is critical for funds of hedge funds to tailor their products to
meet investors’ liquidity needs with no liquidity mismatch or transfer. 2 Equally important, a number
of hedge funds have made their liquidity terms more aligned with investor interests, in some cases by
eliminating provisions in their offering memoranda that previously allowed the use of gates and/or side
pockets of illiquid investments. According to HFR, the number of hedge funds providing quarterly
liquidity or better is approximately 94%, up from 88% at the end of 2007.
Redemption Frequency

Time Period Monthly or better Quarterly liquidity Less than quarterly

12/2007 50.9% 37.1% 12.0%

12/2008 58.9% 32.6% 8.5%

12/2009 62.1% 31.4% 6.5%

Source: Hedge Fund Research

Similarly, among Nexar’s Investable Universe of funds, roughly 30% modified their liquidity terms
over the last twelve months to provide better alignment with investor needs.
Aligning liquidity may provide investors with a better Alpha profile relative to the traditional managed
account model, where restrictive “systematic” liquidity constraints (sometimes daily or weekly
liquidity) imposed by the account sponsor often contribute to the performance differential between the
commingled fund and the managed account, resulting in a potential lack of consistent performance or
Alpha generation. It is important for investors to recognize that there is often a liquidity transfer when
investing with managers that offer a fund or a managed account with different liquidity terms than their
commingled funds, or when they offer a fund with a liquidity profile that is not in line with their
underlying investments or styles. In general, managers making these compromises have difficulty
raising capital in their commingled funds for numerous reasons, including lack of consistent
performance or Alpha. In stressed environments, these managers by definition create a liquidity
transfer that benefits redeeming investors to the potential detriment of remaining investors.

2
We consider that a liquidity transfer has taken place when the liquidity provided to portfolio investors
is inconsistent with the liquidity of the underlying assets, (i.e., a “liquidity mismatch”) - and when an
investor redeeming from such portfolio leaves remaining investors with a less liquid portfolio.

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Fee Compression
Similar to liquidity terms, hedge fund managers and fund of hedge funds managers that adapt their
compensation practices to better align investors’ incentives with their own will be best positioned to
benefit from renewed industry inflows. Increasingly, investors are questioning whether the industry’s
standard 2% management fee and 20% performance fee structure is appropriate given the range of
managers’ strategies and the liquidity of the underlying investments. For example, Calpers (California
Public Employees Retirement System), the nation’s largest public pension fund, has publicly called on
hedge fund managers to re-evaluate both management and performance fees.
According to a survey prepared by Barclays Capital, roughly one-third of hedge fund managers
reduced their fees on existing funds in 2009 and new funds have begun to offer investors reduced fees
in exchange for longer lock-ups. Continued investor pressure is needed, however, to ensure that the
“rationalization” process which is already underway extends more broadly throughout the industry and
that fee models continue to evolve in the best interests of investors. For example, we believe that high
frequency managers with strategies that are less correlated to the traditional broad indices should not
be subjected to the same fee pressures as static funds.

Regulation
Proposed regulations from a variety of bodies in the EU and US are focused on making securities
markets more transparent and stable, which should reassure investors. These initiatives are
exemplified by the European Central Bank’s recent urging that the European Commission “continue
the dialogue with its international partners, in particular the United States, to ensure a globally
coherent regulatory and supervisory framework.” 3 A draft EU directive currently being discussed in
the European Parliament is aimed at identifying and reducing risk in the financial system, but has been
widely criticized by industry participants, regulators and politicians.
In our view, Europe has been a leader in addressing investor concerns. Back in 2002, the European
Union introduced significant changes to its Undertakings for Collective Investments in Transferable
Securities (UCITS) fund format when it adopted the UCITS Management Company Directive
(Directive 2001/107/EC), also known as “UCITS III.” UCITS III permitted UCITS funds authorized
under the laws of one EU member state to be sold in other EU member states. However, beyond
merely allowing collective investment programs to be more easily sold cross-border in the EU, it also
introduced a legislative regime throughout the EU bringing greater transparency and regulation to
UCITS III funds, including funds implementing numerous “hedge fund” strategies, to the benefit of
investors. Specifically, investors benefit from the criteria UCITS III funds impose with respect to
diversification, eligible asset classes, leverage, and liquidity.
Following the success and growth of UCITS III funds, the industry now awaits the implementation of
UCITS IV. 4 Arguably the most significant change under UCITS IV will be the “management
company passport” which will allow management companies authorized in one EU member state to
manage a UCITS fund in another EU member state. It will also bring simplified rules for cross-border
distribution, permit master-feeder structures and improve investor disclosure through the use of a “Key
Investor Information” document. It is our hope that these changes will mean that UCITS products will
continue to offer investors an opportunity to realize the benefits of collective investment, while
providing them with understandable investment products and regulatory protection.

3
Wall Street Journal, October 23, 2009
4
The UCITS IV Directive was approved by the European Parliament in January 2009 and adopted by
the European Council on June 22, 2009

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 Key Regulatory Action - A Focus on Transparency and Stability

EU US

• Greater transparency and regulation
for UCITS III Funds
• “Management company passport”
under UCITS IV
• Improved disclosure through “Key
Investor Information” document
• Hedge fund registration with the SEC?
• Comprehensive review of high frequency
trading, including dark pools, naked access
and flash orders
• CFTC recommends moving OTC derivatives
to formal exchanges

Similar calls for a comprehensive approach to regulatory reform have been made by President Obama,
who wants to modernize and streamline the US regulatory structure and has stressed that new global
regulatory standards are as important as new US standards. Included in President Obama’s agenda for
reform are calls for increased regulation of hedge funds. SEC Chairman Mary Schapiro recently gave
her support to an Obama administration proposal to require hedge funds to register with the SEC.
The SEC initiatives to restore investor confidence in the market, in response to pressure from
legislators in the US Senate and House, also include comprehensive reviews of market practices
related to high-frequency trading, including dark pools, “naked” access, and flash orders:
• Dark pools are electronic order crossing networks that allow traders to avoid showing their
intentions and share price movement, which differs from exchange trading where such
information is available to the public.
• Naked access allows high frequency traders to trade directly on exchanges without the
exchanges or regulators knowing who is making the trades.
• Flash orders permit traders to get a sneak peek at market orders before other investors.
Naked access raises concern about threats to market stability. Dark pools and flash orders raise
concerns of fairness among market participants. The SEC has recently sought to ban flash orders. 5 “If
anyone was hoping for a respite from reform, I am afraid I will disappoint you,” Ms. Schapiro said
recently. 6 Further, Congress is also seeking to regulate the over-the-counter derivatives market, and the
Head of The US Commodity Futures Trading Commission (“CFTC”) has recommended that financial
firms clear swaps through a clearinghouse that would guarantee trades and trade them on regulated
platforms.
Further fueling the urgency for greater regulation are recent “headline events.” In the wake of the
Bernard Madoff Ponzi scheme, Ms. Shapiro said that the agency missed numerous opportunities to
discover the fraud: "it is a failure that we continue to regret, and one that has led us to reform in many
ways how we regulate markets and protect investors." 6
More recently, the SEC action against Galleon Management may open a new offensive against insider
trading in another effort to protect investors. "It would be wise for investment advisers and corporate
executives to closely look at [the Galleon] case…and consider what lessons can be learned and applied
to their own operations," an SEC enforcement official said in a recent press conference. 7

5
SEC Proposes Flash Order Ban, Securities and Exchange Commission Press Release, September 17,
2009
6
Release of the Executive Summary of The Inspector General’s Report regarding the Bernard Madoff
Fraud, Mary L. Shapiro (September 2, 2009)
7
Speech by SEC Staff; remarks at Press Conference, Robert Khuzami (October 16, 2009)

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 “Headline events” bring greater attention and urgency to the need for further
regulation

Although many of the recent developments can be perceived as negative events, we view as positive
the “cleansing” opportunity they have created to review and improve regulations. We are encouraged
by the efforts of governments, regulators and the financial industry to comprehensively evaluate how
markets, trading and regulations have evolved, and to foster global cooperation to draft regulations that
will restore investor confidence and normal market functions. While significant challenges lie in
progressing rationally on the number of fronts which have opened simultaneously and could bring
additional short-term market volatility, the recent effort to bring fairness and transparency to the hedge
fund marketplace is welcome.

We are encouraged by the efforts of governments, regulators and the financial

industry to draft regulations that will restore investor confidence and normal
markets

Conclusion
We believe that the market environment should be conducive to hedge fund investing for the next two
to three years. Hedge fund performance, when compared to the risk-adjusted returns of other asset
classes, is particularly attractive in the current environment - equities are getting more and more
expensive and fixed income markets are expected to become more volatile. Hedge funds should be
compelling investment opportunities, especially with today’s strong trend for better industry practices
and new regulations that should restore investor confidence.
The new market environment and regulations have made it possible for investors to address the
majority of concerns that stemmed from the events of 2008. The potential tradeoff between liquidity
and performance will remain a factor for hedge fund investors. Investors with a need for greater
liquidity will need to be willing to accept lower performance (for example, UCITS III funds, which
offer weekly liquidity) while investors with fewer liquidity constraints will not need to compromise on
performance.
Regardless of investors’ investment time horizons, strict rules need to be applied for the selection of
and allocation among fund managers and a proven process must be applied for investing among
strategies. Active portfolio management (both top-down and bottom-up processes) is crucial for strong
Alpha generation. As part of the top-down process, strategies that may enter into a negative
performance environment should be exited, while capital should be added to strategies where there is a
positive outlook (usually an 18-24 month cycle). Manager selection (bottom-up process) is
indispensable for creating strong Alpha in the invested strategies and avoiding fraud risk. Many
portfolios or funds of hedge funds that focused exclusively on bottom-up processes ran into trouble in
2008 and previous crises when they were left unprotected. Funds that focus primarily on top-down
processes and liquidity are underperforming this year as they lack exposure to strategies and managers
presently generating strong Alpha. The key is finding the right combination of both top-down and
bottom-up processes within a strong risk oversight framework while simultaneously meeting the
constraints provided by the broader industry, customers and regulators.
Transparency and appropriate liquidity are paramount to any legitimate risk management process as
these are indispensable for experienced market professionals to monitor hedge fund exposure and take
proper action as necessary on a timely basis. The hedge fund industry, facilitated by reputable third-
party risk aggregators, custodians and administrators, is generally providing more transparency and
liquidity to investors. Funds of hedge funds can already benefit from these developments by investing
only in transparent hedge funds, insisting on the use of only reputable independent service providers

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and offering frequent independent aggregated risk reports. Portfolios may also be structured with
different investment horizons and liquidity profiles (or tailor-made for one investor only).
These tasks should be left to teams of market professionals who can analyze strategies and help
investors ensure a portfolio’s investment horizon meets their requirements. Such professionals will
have to monitor the liquidity of the underlying funds and any style drifts that can lead to a change in
investment horizons of the underlying funds. They must constantly monitor the probability of gates
being imposed or side pockets being created by underlying managers and take proper action to prevent
such events. The success of each portfolio management team resides in its ability to combine risk
management processes, with top-down and bottom-up portfolio management, while working within
industry, investor and regulatory constraints. Investors can now measure and evaluate portfolio
management teams’ quality and inputs by using the tools and transparency they previously lacked,
within a continuously improving regulatory framework.

• Hedge fund performance is particularly attractive in the current environment

when compared to the risk-adjusted returns of other asset classes
• The new market environment and regulations have made it possible for investors
to address the majority of the concerns stemming from the events of 2008
• Active portfolio management is crucial for strong Alpha generation
• The success of each portfolio management team resides in its ability to combine
risk management processes, with portfolio management, while meeting all
stakeholders’ constraints

Acknowledgements:
Paulo Baia, Head of Research
Douglas Siekierski, Chief Operating Officer
Jason Lovelace, Chief Risk Officer
Scott Beechert, General Counsel

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