Expected Return cash

equity

Expected Risk cash

equity

Liquidity low

natives as an important tool in mitigating portfolio risk, limiting

excellent

Availability of Product poor

Endow/
Foundation

Taft-Harley

Liquidity low

equity

Liquidity low

high

Availability of Product poor

Expected Risk cash

Currency

15%
5%

Limited opportunity set, potential for illiquidity.

Expected Return cash

equity

Expected Risk cash

equity

Liquidity low
Availability of Product poor
Fees and Expenses low

high
excellent
high

high
excellent
high

ABS

OL

HEDGE FUND
Multi-Strategy

equity

Expected Risk cash

equity

Liquidity low

RE

Expected Return cash

equity

Expected Risk cash

equity

Liquidity low
Availability of Product poor
Fees and Expenses low

high
excellent

excellent
high

Fees and Expenses low

Expected Return cash

Expected Risk cash

high

Availability of Product poor

Liquidity low

excellent

Fees and Expenses low

Availability of Product poor

high

Fees and Expenses low

excellent

equity
equity
high
excellent
high

Long/Short Equity

Expected Return cash

Expected Risk cash
Liquidity low
Availability of Product poor
Fees and Expenses low

UIT
EQ

UT

high

Availability of Product poor

International Small Cap

Expected Return cash

equity
high
excellent
high

Emerging Markets

Private Equity

equity

Expected Return cash

Opportunity set is small, considered as a

diversifier within the context of a broader
strategy, limited institutional products.

equity

Fees and Expenses low

HEDGE FUND
Emerging Markets

excellent

UR

Sufficient opportunity set, allocations are

typically carved out of broad asset classes at
the manager structure level.
(rather than at the asset allocation level).

Expected Risk cash

Availability of Product poor

Source: Callan. Average figures. Includes funds with no alternatives allocations.

Wide opportunity set, attractive return and

diversification benefits, viable for inclusion in
large institutional portfolios.

equity

Liquidity low

Total

SIZE OF OPPORTUNITY SET

Expected Return cash

equity

high

Fees and Expenses low

high

equity

Expected Risk cash

Liquidity low

high

Fees and Expenses low

high

Availability of Product poor

excellent

Corporate

equity

Expected Return cash

high

high

equity

AS

Public

Expected Risk cash

excellent

0%

equity

excellent

Expected Return cash

CL

10%

equity

4%

6%

equity

Expected Risk cash

Availability of Product poor

Non-U.S. Fixed Income

SE

3%

9%

Expected Return cash

high
high

Expected Return cash

High Yield

S
-A

12%
5%

Fees and Expenses low

Frontier Markets

Liquidity low

high

Fees and Expenses low

high

TI
UL

10%

equity

Liquidity low

equity

20%

equity

Expected Risk cash

Expected Risk cash

Liquidity low

Fees and Expenses low

Expected Return cash

equity

Availability of Product poor

Global Tactical Asset Allocation (GTAA)

HEDGE FUND
Event Driven

Expected Return cash

equity

as alternatives can pose implementation challenges. Please see

the reverse side for more details on each strategy.

31%

Bank Loans

excellent
high

high

Fees and Expenses low

strategies that Callans clients are examining and implementing.

Investors must assess their funds unique needs and risk preferences to decide whether or not these strategies are appropriate,

excellent
high

high

equity

Expected Risk cash

This charticle looks at alternatives from the ground up, focusing on

30%

Fees and Expenses low

high

Emerging Markets Debt

Availability of Product poor

40%

equity

Liquidity low

Liquidity low

3rd Quarter 2012

Expected Risk cash

Availability of Product poor

Expected Return cash

volatility, and outperforming the broader market.

3rd Quarter 2002

Availability of Product poor

Risk Parity

equity, international developed equity, and investment-grade

U.S. fixed income). A growing number of investors now see alter-

% OF PORTFOLIO IN ALTERNATIVES (2002 v. 2012)

equity

Fees and Expenses low

lower correlations with more traditional asset classes (U.S.

equity

Expected Return cash

excellent
high

Fees and Expenses low

equity

Expected Risk cash

Liquidity low

high

Availability of Product poor

Expected Return cash

investors are putting down roots in alternative investments. Alternatives attract investors with the potential for higher returns at

HEDGE FUND
Managed Futures

ED I
NCO
M

In an environment characterized by low returns, institutional

HEDGE FUND
Global Macro

FIX

Alter natives
in a Nutshell

HEDGE FUND
Distressed Debt

REAL
ASSETS*

Expected Return cash

equity

Expected Risk cash

Expected Risk cash

equity

Liquidity low

Liquidity low
Availability of Product poor
Fees and Expenses low

high

Please see Callans charticle

Real Return Strategies for
additional information.

high
excellent
high

Availability of Product poor

Fees and Expenses low

equity
equity
high
excellent
high

Bank Loans: Syndicated or private loans (i.e.,

the futures or options markets. Traders take long and

short positions in forward and futures contracts, and
options on futures contracts, including global currency,
interest rate, equity, or commodities. Typically run by
Commodity Trading Advisors (CTAs). CTAs are momentum traders or trend followers with well-designed
trading models.

Diversification through number and variety of markets

Low correlation to stock and bond returns
Ability to profit in up- and down-trending markets
Leverage, high fees, and potential illiquidity
Potential for large drawdown periods
Generally rely on trending markets to generate returns

Indices: HFRI Macro Systematic Diversified, Absolute

return of Libor (or T-bills) + X%

Currency: An actively managed strategy seeking

Event Driven: Long or short investments in securi-

Emerging Markets Hedge Fund: Long or short

investments in emerging markets securities, including
commodities, real estate, currencies, and derivatives,
made with leverage. Many emerging markets do not
allow short selling or offer derivatives with which to
hedge. Heavily long-biased strategies with discretionary cash are common.

Difficult to benchmark
Use of leverage and short selling

Indices: Barclays Currency Traders, HFRI Currency

benefits

Large, liquid market

Identifiable inefficiencies (e.g., assessing value using
purchasing power parity model)

ties of a corporation that is going through a merger,

corporate restructuring, liquidation, bankruptcy, or other
event. Returns are generated by correctly identifying
the change in value of the underlying security. Three
popular sub-categories are: risk arbitrage, distressed
securities, and multi-strategy.

Risks

Risks
Risks benefits

excess returns regardless of existing foreign currency

exposures. Mandates typically use carry, trend, value,
and volatility trading strategies to generate returns.
Absolute-return-oriented mandates that employ long
and short positions on a tactical basis. Investments include spot, forward, or other derivative contracts, and
often employ leverage (at risk levels deemed acceptable by the investor).

Opportunity set driven by functioning capital markets and

corporate actions
Diversification over business cycles
Value-biased strategy
Extremely sensitive to market dislocations
Crowding of trades on specific events
Opportunity set limited in the absence of economic
events and/or corporate activity

Index: HFRI Total Event Driven

benefits

Indices: MSCI World, Absolute return of Libor

(or T-bills) + X%, HFRI Total Macro

Geographical diversification
Broader exposure to emerging market securities
Less efficient than developed markets

Risks

Indices: Standard public asset allocation policy, Absolute return of Libor (or T-bills) + X%, HFRI Total Macro

Leverage and potential for illiquidity

High volatility of returns
Limited access to reliable investment information
Less investor protections than in developed markets

Index: HRFI Emerging Markets Global

Risks benefits

Interest rate, credit, and default risk

Unregistered securities

Index: S&P Leveraged Loan

Global Macro Hedge Fund: Similar to GTAA,

global macro actively allocates across asset classes
and instruments, regardless of direction, but mandates
have fewer constraints and take long or short positions.
Managers use a combination of relative value trading
(i.e., discretionary), value investing, and momentum or
trend following (i.e., systematic) trading strategies.
benefits

High management fees

High turnover


Difficult to monitor and benchmark

Managed Futures: Investments that speculate on

Hedges interest rate risk when yields rise

Higher recovery rates (lower defaults) than high yield
Lower volatility of return than high yield

Potential to profit over rising or falling markets

Diversification of markets and instruments
Manager skill utilized (not algorithm/model based)

Risks

Potential to profit over rising and falling markets

Efficient portfolio diversifier given short-term orientation
Flatter fee structure than hedge fund world

Indices: JP Morgan EMBI (Sov. - USD), CEMBI (Corp.

- USD), GBI-EM (Sov. - Local)

Implementation (wide return dispersion)

Flat returns during macro economic uncertainty
Higher fees based on performance

Heavy country concentrations

Limited product availability and capacity
Much higher manager and custody fees than em. markets

Index: MSCI Frontier Markets (Standard or IMI)

Distressed Debt: Bonds or claims on companies or

government entities that are either already in default,
under bankruptcy protection, or moving toward default.
Often CCC or below credit ratings, typically no current
income, and trade at a substantial discount. Opportunities available in private equity, hedge funds, real estate,
or fixed income with different lock-up structures.
Significant upside return potential if turnaround
materializes
Illiquidity premium
Interest rate, credit, and default risk
Legal and financial risk
Indeterminate exit point

Indices: HFRI Distressed/Restructuring, Altman-NYU

Salomon Center Defaulted Debt Performance

Founded in 1973, Callan Associates Inc.

is one of the largest independently owned
investment consulting firms in the country.
Headquartered in San Francisco, Calif.,
the firm provides research, education, decision support, and advice to a broad array
of institutional investors.

Indices: MSCI World, Absolute return of Libor

(or T-bills) + X%, HFRI Total Macro

Multi-Strategy Hedge Fund: Investments across

hedge fund strategies. Four broad categories are: equity hedge, event-driven, macro, and relative value.
Multi references the multiple underlying sub-strategies within each category. Managers maintain long
and short positions and frequently use derivatives.

Risks benefits

classes globally. Manager makes tactical bets on asset

classes, markets, or securities. Tends to be long-only
investments in global equity, currency, bonds, commodities. Uses industry or sector selection, security
selection, as well as market timing components. Strategies are typically purely quantitative. Risk profiles and
leverage levels range widely.

Interest rate, credit and default risk

Currency, political, and economic risk
Higher manager fees than developed market fixed income

benefits

Cost of leverage detracts from returns

Continuous oversight
More sensitive to interest rate movements

GTAA: Exploits short-term mispricing across asset

Enhanced income over developed market bonds

Increased diversification due to interest rate, credit, and
currency cycles

Risks

benefits

Diversification of equity risk

Superior risk-adjusted performance over periods of
extreme equity volatility

Risks

contributes equally to total portfolio risk that are constructed via risk allocation (not the traditional capital
allocation). Greater allocations to fixed income and
other low volatility strategies reduce the proportion
of total risk from equity. Leverage is typically used to
achieve the targeted return. Risk parity products tend
to be global and many have a tactical element.

Indices: Citigroup Non-U.S. (World Government

Bond) Index - Sovereign, Global Aggregate ex-U.S. Sovereign and Corporate

benefits

Interest rate, credit, and default risks

More equity risk than investment-grade fixed income
Illiquid

Interest rate, credit, and default risk

Currency risk

Risks

Risks

Higher current income than U.S. investment grade

Low correlations to U.S. stocks and bonds

Increased diversification due to interest rate, credit,

currency, and economic cycles
Potential use of hedging to add currency value

credit provided by a group of lenders with a single set

of terms), administered by one or more commercial
or investment banks. Loans are senior to other debt
within the capital structure. Can be investment grade
or non-investment grade (i.e., leveraged loans). Coupons float with changes in market interest rates (e.g.,
3-month LIBOR plus a spread).

benefits

Emerging Markets Debt: Debt issued by developing market economies, primarily by sovereigns (corporations tend to borrow from banks or other sources).
Corporate issuance is increasing and credit ratings
are shifting from predominately non-investment grade
to investment grade.

Risks

Non-U.S. Developed Fixed Income: Investmentgrade sovereign or corporate debt from developed
nations. Offers diversification across interest rate, currency, and economic cycles around the globe. Potential
for added volatility of return due to currency exposure.

benefits

High Yield: Unsecured debt issued by companies

with below investment-grade credit ratings (also
called non-investment grade, speculative, or junk
bonds). Bonds carry a high risk of defualt for an adverse credit event, but attract investors with typically
higher interest rates. Can also be repackaged into
collateralized debt obligations (CDOs).

Risks

Indices: MSCI World ex-U.S. Small Cap,

ACWI ex-US Small Cap

Risks benefits

Indices: DJCS Long/Short Equity, Long-only MSCI

ACWI IMI

Lower correlation to developed equity returns and

between frontier countries
Market inefficiencies

benefits

Higher volatility (less established companies)

Smaller opportunity set, potential for illiquidity
Limited product capacity
Higher fees than large cap and developed equities

Frontier Markets: Seek to gain access to preemerging countries with investable stock markets with
faster economic growth than emerging markets. Additional risks beyond emerging markets may include
structural issues (legal, regulatory), substandard financial reporting, currency convertibility and volatility,
and dependence on a limited number of sectors (e.g.,
Financials and Telecoms).

Risks

ben.

Potential for illiquidity

Higher fees than long only, managers largely unregulated
Relies on active management, which can be ineffective
in macro-driven environments
Lack of custodial control

Higher expected risk-adjusted returns from small cap premium

More potential for diversification within public equities

Risks

ben.
Risks

Illiquidity and complexity

Implementation risk due to high dispersion of returns
Significantly higher fees

Returns not dependent on stock/bond market cycles

Managers can profit during up and down market cycles

International Small Cap: Equity investments in

companies domiciled outside of the U.S. with less
than $5 billion of market capitalization (size can vary
by country), and whose stock is often not included
in the standard developed market indices. Small cap
stocks rarely pay dividends, so price appreciation is
based on future growth expectations.

Indices: Broad market listed public equity index,

Private Equity Performance Database

Risk Parity: Portfolios where each asset class

Multi-Asset Class

Return enhancement from illiquidity or inefficiency

premium
Potential for outperformance driven by private equity
managers control over the portfolio companies

Long/Short Equity: Buying (long) undervalued and

selling (short) overvalued securities to beat long-only
equity benchmarks with bottom-up stock selection and
variable market exposures. Managers can shift within
styles, cap ranges, and net short or long positions.
Funds increasingly have limited capacity.

Indices: MSCI Emerging Markets (Standard or IMI),

part of ACWI ex-US

Indices: Merrill Lynch High Yield Master, Barclays

High Yield, CSFB High Yield

Absolute Return

in operating companies accessed through limited

partnerships. Companies are managed for long-term
capital gains. The most popular strategies are leveraged buyouts, venture capital, growth capital, distressed investments, and mezzanine debt.

benefits

Risks

Higher volatility than developed markets

Illiquidity associated with local stock exchanges
Higher manager and custody fees than developed equities

Private Equity: Private, unregistered investments

Risks

benefits

Higher expected returns due to rising GDP growth

Diversification (broader equity opportunity set)
Market inefficiencies

benefits

Equity
Fixed Income

Emerging Markets Equity: Stocks issued by companies in developing economies, which are expected
to have higher GDP growth due to global integration,
increased supply chains to developed economies,
and rising wages and consumption patterns. Investors
should consider political instability, inadequate infrastructure, legal concerns, and currency volatility.

For more information please contact your

Callan consultant.
San Francisco
800.227.3288
Atlanta

Chicago

Diversification of single strategy hedge fund risks

Flexibility to capitalize on best opportunity
Increased investment capacity

800.522.9782 800.999.3536

Muted performance if certain strategies are out of favor

Higher fees based on performance

855.864.3377 800.274.5878

Indices: Absolute return of Libor (or T-bills) + X%,

DJCS All Hedge Multi-Strategy, HFRI Multi-Strategy
Equity, Event Driven, Macro, and Relative Value

Denver

New Jersey

www.callan.com
Dec. 2012 | 2012 Callan Associates Inc.