Dead Strategies and Other Travails:

Dead Strategies and Other Travails: An Update on Hedge Funds

March, 2005

R. McFall Lamm, Jr. (Ph.D.)Chief Investment Strategist, DB Absolute Return Strategies (ARS)/

Global Investment Management

Deutsche Bank

New York/London

Page 2

Agenda

Flows and cyclical issues

The hedge fund cycle

Strategy-by-strategy update

Flows and Cyclical Issues

Page 4

Smart Money? Stark Differences Remain between Institutional vs. Endowments Market Exposure

Institutions continue to move slowly into alternatives:

Rationale is to correct prior overconcentration in stocks and bonds, underperformance, and new funding pressure. Represents herding behavioral pattern in chasing past returns.

Ivy Endowments Asset Allocation

Equity38%

Hedge funds22%

Bonds18%

Other6%

Real estate7%

Private equity6%

Venture capital

3%

Source: endowment annual reports.

US Corporate Pension Funds: 2004 Asset Allocation

Fixed income29%

International stocks

15%

Domestic stocks

46%Hedge funds

1%Private equity

4%

Other1%

Real estate4%

Source: Greenwich Associates.

Page 5

Smart Money Paranoia: Where to Go Next?

Future Institutional Investor Asset Allocation Shifts

Company stock

Hedge funds

Private equity

Real estate

Fixed income

Intl.stocks (passive)

Intl. stocks (active)

US stocks (passive)

US stocks (active)

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

Greater by 2006

Lower by 2006

Source: Greenwich Associates

Endowments and ultra high net worth investors fear the ongoing institutionalization of the alternative market due to its negative effect on returns—to many, the game is over.

There is extreme intellectual fragmentation and a lack of any consensus on where the new investment frontiers are. Many recycled old ideas promulgated as new are dismissed as plain vanilla.

As a result, there is rising pressure on investment professionals.

Alternatives to Public Markets: Growth in Private Assets Under Management

$0.0

$0.2

$0.4

$0.6

$0.8

$1.0

$1.2

$1.4

$1.6

81 83 85 87 89 91 93 95 97 99 01 03

Tri

llio

n

Buyouts and mezzanine funds

Venture capital

Hedge fund assets

Source: Thomson Venture Economics, CISDM, and HFR.

Page 6

New Investment Frontiers or Rediscovery?

Macro issues

Mid-cycle or late cycle

Search for real returns

Dead strategy risk in HFs

Reinflation implications

Emerging markets—profitable growth or not

Small cap vs. micro cap

Global integration inducing rising market correlation

Systematic risk/leverage

Post modern portfolio theory

Higher order moments (asymmetry) optimization

Risk management vs. asset allocation

Strategy allocation or asset allocation

Manager selection vs. indexing

Strategic vs. tactical asset allocation

TIPs as risk-free asset

Alpha transfer or camouflaged beta

New rediscovered assets

Farmland/timberland

Art/collectibles

Oil/gas partnerships

Insurance-linked securities

Real estate

Commodities/currencies

CDOs/derivatives

Value and dividends

Page 7

Life vs. Asset Cycles

Bubbles arise as naïve investors bid up asset prices beyond rationale equilibria.

The process arises due to linear extrapolation of the recent past by inexperienced short-termers.

Elongated business cycles are extending the duration of bubbles. This complicates predicting how long the Ponzi phase can endure.

The Collectible Art Cycle

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

1 2 3 4 5 6 7 8 9 10 11 12 13

Years into cycle

Beg

inn

ing

yea

r =

100

1997

1982

1965

Mei-Moses Index

Source: AER

Commodity Super-Cycles

-50

0

50

100

150

200

250

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57

Months from trough

Ind

ex

va

lue

, 1

st

mo

nth

= 1

00

50

100

150

200

250

300

350

Re

al

ind

ex

, 1

st

mo

nth

= 1

00

Jan 72

Sept 77

Jan 02

CRB Index

Nominal values (left)

Real values (right)

Real values are obtained by deflating by the CPI. Source: Bloomberg.

Commercial Real Estate Cycles

$80

$100

$120

$140

$160

$180

$200

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69

Months from trough

Ind

ex,

beg

inn

ing

mo

nth

= 1

00

Jul-82

Oct-90

Oct. 02

Equity REIT Price Index deflated by CPI

Source: NAREIT, BLS. Note correlation with business cycle.

The Hedge Fund Cycle

Page 9

Hedge Fund Performance is Largely Derivative

Returns are linked to performance in markets where HF positions are concentrated.

Equity and credit spread returns continue to explain most of the variation in HF performance.

The HF cycle therefore is empirically a direct function of equity market behavior and credit spread developments.

Hedge Fund Performance vs. Stocks and Bonds

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Treas. bonds HF composite

S&P 500 FOFs

Year-over-year returns

Hedge Funds vs. Equity Returns

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

HF composite

S&P 500

FOF composite


Source: S&P, DB.

Hedge Fund Returns Versus Credit Spreads

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

91 92 93 94 95 96 97 98 99 00 01 02 03 04

HF composite

FOFs

HY less Treas. return


Source: DB, Bloomberg

Page 10

Alpha Decay and Dead Strategies

Risk-adjusted HF returns are declining:

Attributable to market inflows causing capacity exhaustion.

Some strategies are being labeled “dead” by pundits—eg., equity market neutral, stat arb, convertible arbitrage, and merger arbitrage,

New questions are also being raised about CTAs/managed futures after 04’s large drawdown.

Hedge Fund Return Correlations with Other Market Aggregates

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

HF returns vs. S&P

HF returns vs. credit spreads

HF returns vs. VIX

Trailing 24-month correlation

Source: DB, Bloomberg.

Trendline Performance for Selected Hedge Fund Strategies

-10%

-5%

0%

5%

10%

15%

20%

25%

92 93 94 95 96 97 98 99 00 01 02 03 04

Convertible abitrage Equity market neutral Merger arbitrage


Source: index of indexes from EAI, CSFB, HFR, Hennessee, Altvest, VanHedge, and TUNA.

CTA/Managed Futures Returns

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Year-over-year performance

Source: Average of available indexes from Barclays, TUNA, EAI, and CSFB.

Page 11

Thematics and IssuesHedge Fund Strategy Returns, '03 vs. '04

1.2%

5.8%

3.5%

2.5%

4.5%

17.7%

12.4%

-6.7%

14.9%

3.7%

4.9%

10.9%

3.5%

1.4%

8.8%

-10% -5% 0% 5% 10% 15% 20% 25% 30% 35%

Convertible arb

Fixed income arb

Eq. market neutral

Statistical arb

Merger arb

Distressed debt

Event

Long/short

Short

Emerging market

Discretionary macro

Systematic/CTAs

S&P 500

Treas. bonds

3-mo. Treas.

2003

2004

Source: hedge fund performance based on a compilation of indexes from EAI, CSFB, HFR, Altvest, Hennessee, VanHedge, and Tuna; other data from Bloomberg.

Key industry questions:

Alpha decay—dead strategy risk from inflows and institutionalization reducing risk-taking and entrepreneurial flare.

Indexing appears to be a failure.

Correlation with equity performance continues high—alpha or camouflaged beta?

Hedge Fund Returns

$95

$97

$99

$101

$103

$105

$107

$109

Dec Jan

Feb Mar Apr

May Ju

nJu

lAug

Sep OctNov

Dec Jan

Feb Mar

Dec

. 31,

200

3 =

$10

0

HFRX investable index

SPHG investable index

Industry FOF composite

Industry composite

Source: The monthly composite consists of an average of reported returns from HFR, CSFB, VanHedge, and Hennessee while fund of funds returns are from HFR, VanHedge, and TUNA through October. The November figure is an estimate. The HFRX and SPHG are from HFR and S&P, respectively, through Nov. 30.

Maturing of industry implies returns will come from robust portfolio management: Strategy allocation Manager selection

Distinction from private equity blurring with HFs bidding on new deals.

Page 12

Equity Cycle Considerations

Lessons from Past Cycles: Stock Prices vs. Growth

-40%

-30%

-20%

-10%

0%

10%

20%

0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

-20%

-10%

0%

10%

20%

30%

40%

Quarters beyond trough

Real GDP, past cycles (left)

Real GDP, current cycle (right)

S&P 500 Index change, past cycles

S&P 500 Index change, current cycle

Average of Past Seven Cycles

Source: Bloomberg

Modest equity returns expected due to:

Stage of cycle—profit growth moderating. Rising interest rates—higher discount factor and cash offering a better substitute. Restrained demand due to post-bubble risk aversion and alternatives attracting funds. Absence of extreme undervaluation.

S&P Change vs. Economic Growth: Stocks Lead Dynamically

-4%

-2%

0%

2%

4%

6%

8%

-8 -7 -6 -5 -4 -3 -2 -1 0 0 0 0 1 2 3 4 5 6 7 8Quarters before (after) recession

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Real GDP (left, annualized)

S&P 500 Index (quarterly)

Average of last seven cycles

Source: Bloomberg

Equity Market Performance Over the Past Five Years

$20

$40

$60

$80

$100

$120

$140

2000 2001 2002 2003 2004

Dec

. 199

9 =

$10

0

S&P 500 Russell 2000 NASDAQ composite

International Emerging markets

Source: Bloomberg

Page 13

Equity Cycle Considerations (Cont’d)

S&P Price to Earnings Ratio vs. 10-Year Treasury Rates

0

5

10

15

20

25

30

35

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

0%

2%

4%

6%

8%

10%

12%

14%

16%

Price/earnings ratio (left axis)

10-year Treas. Rate (right, inverted)

Source: CEA, DB forecasts.

Monthly Mutual Fund Net Flows

-$70

-$60

-$50

-$40

-$30

-$20

-$10

$0

$10

$20

$30

$40

$50

97 98 99 00 01 02 03 04

Bill

ion

s

-$20

-$10

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

Equity (left axis)

Bonds (right axis)

Source: Investment Company Institute.

Pension Funding Status of the S&P 500

-$0.5

-$0.3

$0.0

$0.3

$0.5

$0.8

$1.0

$1.3

$1.5

SurplusLiabilitiesAssets

Source: Standard and Poors; DB forecast for 2004.

Short Interest Outstanding Generally Holding Flat Recently

0

2

4

6

8

10

12

14

16

01 02 03 04

Tri

llio

n s

har

es

AMEX

NASDAQ

NYSESource: AMEX, NASDAQ, and NYSE.

Page 14

Equity Cycle Considerations (Cont’d)

US Merger and Acquisition Activity

$0

$500

$1,000

$1,500

$2,000

$2,500

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

$m

illi

on

Total value of deals

Stock vs. Bond Market Risk

0%

5%

10%

15%

20%

25%

30%

35%

40%

74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

S&P volatility

US bond volatility

Ratio (right)

Trailing 24 months

Volcker

'87 crash

Source: Bloomberg.

US New Equity Issuance

$0

$50

$100

$150

$200

$250

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

$bill

ion

Additionals

IPOS

Source: Bloomberg

VIX vs. Realized S&P Volatility

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Realized trailing 2-year vol

VIX index

Source: VIX from Bloomberg; trailing vol via author's calculations

Page 15

Credit-Spread Cycle: Room to Run

High Yield Default Rates vs. Implicit Default Risk Indicator

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Annual default rate (right axis)

High yield/corporate bond yield ratio (left)

Source: Bear Sterns, Merrill Lynch

Fixed Income Asset Correlations with Treasury Securities

-1.0

-0.5

0.0

0.5

1.0

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Corporate MortgageAgency High yieldEmerging mrkts. ConvertsTIPS

Source: Derived from Merrill Lynch data.

Trailing 24-months

Credit Spreads: Nearing Mid-90s Levels

0

5

10

15

20

25

92 93 94 95 96 97 98 99 00 01 02 03 04 05

Yie

ld t

o m

atu

rity

(%

)

3-mo. Treas. Treasuries Corporate Mortgage

Agency High yield Emerging mrkts.

Source: Merrill Lynch

Mexican peso crisis

Russian debt default

WorldCom default

Volatility of Fixed Income Asset Classes

1%

10%

100%

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Treasuries CorporateMortgage AgencyHigh yield Emerging marketsConverts TIPS

Trailing 24-month standard deviation

Source: Derived from Merrill Lynch data.

Page 16

Forecasts and Strategy-by-Strategy Views

Page 17

Market Views (Absent Shock)

Recent Return History and Forecasts Strategy 01 02 03 04 05F

Hedge fundsConvertible arb. 12.8% 9.2% 11.3% 1.2% 1-2%Fixed income arb. 6.4% 6.1% 6.4% 5.8% 4-6%Equity market neutral 6.5% 1.3% 2.2% 3.5% 1-3%Merger arb. 3.2% -1.8% 8.8% 4.5% 3-6%

Distressed debt 15.0% 4.4% 27.1% 17.7% 6-10%Equity long/short -1.0% -4.4% 19.4% 8.8% 5-8%Discretionary macro 3.8% 1.2% 20.6% 3.7% 4-8%CTAs/mngd. futures 2.5% 16.0% 13.2% 2.9% 5-9%FOF index 3.9% 1.6% 11.7% 6.9% 4-6%HF composite 5.0% 1.1% 17.9% 7.9% 5-7%

Traditional assets Large caps (SPX) -11.9% -22.1% 28.7% 10.9% 6-11% Small caps (RTY) 1.0% -21.8% 45.4% 15.0% 4-14%Convertibles (Merrill) -4.0% -5.0% 25.8% 8.5% 4-5%Bonds (Merrill Treas.) 6.7% 11.6% 2.3% 3.5% 2-3%High yield (Merrill) 6.2% -1.9% 27.2% 10.9% 5-8%Cash (3m Treas. ave.) 3.4% 1.6% 1.0% 1.4% 2.9%

Source of historical hedge fund data: index of indexes from major data disseminators.

Page 18

Low Vol Strategies: Struggling to Beat Cash

Return Contribution from the Convertible Arb Short Equity Hedge

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

Convertible arb less convertible returns

Russell 2000 returns (right, inverted)

Year over year returns

Source: Merrill Lynch and DB.

Determinants of Convertible Security Returns

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Convertible securitiesRussell 2000High yieldRussell 2000 realized volatility


Source: Bloomberg, Merrill Lynch

Equity Market Neutral Performance vs. Value/Growth Rotations

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

02 03 04 05

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

Equity market neutral (left)

Barra S&P Value Index less NASDAQ


Source: Bloomberg, DB.

Fixed Income Arbitrage Returns vs. Treasury and Corporate Yields

-15%

-10%

-5%

0%

5%

10%

15%

20%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Fixed income arb returns

3-mo. Treasuries

Treasury bonds

Investment grade corporate

High yieldSource: Merrill, DB.

Page 19

Mid-Vol Strategies: Event-Driven Attractive on Risk/Return

Global Merger and Acquisition Activity Rising Again

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

$500

Bill

ion

s

0

10

20

30

40

50

60

Per

cen

t

Volume (left)

Average premium paid (right)

Source: Bloomberg

Distressed Debt vs. High Yield Bond Returns

-20%

-10%

0%

10%

20%

30%

40%

50%

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Distressed debt hedge funds

High yield securities


Source: Merrill Lynch, DB.

Time-Varying Hedge Fund Strategy Skew

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Convertible Fixed income arbMarket neutral Merger arbDistressed Long/shortDiscretionary SystematicS&P 500

Trailing 24-months

Hedge Fund Strategy Volatility

0%

5%

10%

15%

20%

25%

92 93 94 95 96 97 98 99 00 01 02 03 04 05

Convertible Fixed income arbMarket neutral Merger arbDistressed Long/shortDiscretionary Systematic

Trailing 24-months

Page 20

High-Vol Strategies: Equity and Trend Dependent

S&P Managed Futures Index vs. the Euro

950

1000

1050

1100

1150

1200

1250

S&

P i

nd

ex

, D

ec.

31

, 2

00

2 =

10

00

-$0.10

-$0.08

-$0.06

-$0.04

-$0.02

$0.00

$0.02

$0.04

$0.06

$0.08

$0.10

De

via

tio

n f

rom

tre

nd

in

do

lla

rs

Euro (trend deviation, right axis)

S&P managed futures index

Correlation > 90% over past year

Source: Bloomberg.

Equity Long/Short Fund Returns vs. the Russell 2000

-60%

-40%

-20%

0%

20%

40%

60%

80%

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Long/short

Russell 2000


Source: Bloomberg, DB.

Discretionary vs. CTA/Managed Futures Return Correlation

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

92 93 94 95 96 97 98 99 00 01 02 03 04 05

Trailing 24 months

Source: results of internal analysis

Implicit Stock Exposure Carried by Long/Short Equity Hedge Funds

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

92 93 94 95 96 97 98 99 00 01 02 03 04 05

Russell 2000

NASDAQ Composite

S&P 500

Based on trailing 24-month return regressions

Source: Bloomberg

Page 21

Selected References

Lamm, R.M. “Why Not 100% Hedge Funds?” The Journal of Investing, Winter (1999), 87-97.

_____. “How Good Are Equity Hedge Managers,” Alternative Investments Quarterly, January (2002), pp. 17-25.

_____. “Asymmetric Returns and Optimal Hedge Fund Portfolios,” The Journal of Alternative Investments, Winter (2003), 9-21.

_____. “Addressing the Issues and Challenges of Hedge Funds as an Asset Class,” Integrating Hedge Funds into a Private Wealth Strategy: AIMR Conference Proceedings, January (2004), 21-32.

_____. “The Hedge Fund Revolution,” Journal of Financial Transformation, February (2004), 87-95.

_____. Benchmarking Hedge Fund Performance: An Index of Indexes Approach, Deutsche Bank research monograph, January, 2004; updated January 2005.

_____. “Why Not 100% Hedge Funds? Still A Viable Approach” The Journal of Investing, Winter (2004), 12-20.

_____. “The Answer to Your Dreams?” The Journal of Alternative Investments, forthcoming, Spring (2005).

Page 22

Important – Please NoteR. McFall Lamm, Jr. is Chief Investment Strategist, DB Absolute Return Strategies (ARS) / Global Investment Management for Deutsche Bank in New York/London. This document is for discussion purposes only and not available for quotation. The opinions and analyses, including any predictions, expressed herein are those of the author and do not necessarily reflect those of Deutsche Bank. Such opinions and analyses involve a number of assumptions which may not prove valid. Any suggestions contained herein are general, and do not take into account an individual’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any governmental entity) and are not guaranteed by or obligations of Deutsche Bank. These products are subject to investment risk including possible loss of principal. The past performance of a product or service does not guarantee or predict future performance. No warranty or representation, express or implied, is made by Deutsche Bank, nor does it accept any liability with respect to the information set forth herein. Distribution hereof does not constitute legal, tax, accounting or other professional advice. Recipients should consult their applicable professional advisors prior to acting on the information set forth herein.

Sources for all charts are Datastream, Bloomberg, or Deutsche Bank unless otherwise noted.

All opinions and estimates herein, including forecast returns, reflect our judgement on the date of this report and are subject to change without notice. These opinions and analyses involve a number of assumptions which may not prove valid. The past performance of securities and other instruments does not necessarily indicate or predict future performance.

“Deutsche Bank” means Deutsche Bank AG and its affiliated companies, including Deutsche Bank Trust Company Americas, as the context requires. Deutsche Bank Private Wealth Management refers to Deutsche Bank’s wealth management activities for high-net-worth clients around the world.

Appendix

Page 24

DB Absolute Return Strategies (DB ARS) Overview

• $8.9 billion USD invested in hedge funds assets

• 15 different fund of funds

• Single manager platform with 15 funds

• Over 140 professional with offices in New York City, Summit, NJ, London, Frankfurt and Tokyo

• Fiduciary orientation with focus on risk management

As of January 1, 2005

Page 25

Contact Information

Geoffrey S. Moore, Director

Deutsche Asset Management Canada Limited

(514) 875-5163

[email protected]

Documents

Dead Strategies and Other Travails: