ACTUARIAL INSIGHTS ACTUARIAL INSIGHTS INTO HEDGE FUND INTO HEDGE FUND

MANAGEMENTMANAGEMENT

R S ClarksonR S Clarkson

Risk is downside in natureRisk is downside in nature Look beyond the recent past.Look beyond the recent past.

Watch out for departures from prudent Watch out for departures from prudent behaviour.behaviour.

There is nothing to fear but fear.There is nothing to fear but fear. Equities, not bonds or cash, for the long Equities, not bonds or cash, for the long

run.run. Beware of rising inflation.Beware of rising inflation.

The power of developing nations.The power of developing nations. Investment of the fourth kind.Investment of the fourth kind.

RISK IS DOWNSIDE IN NATURERISK IS DOWNSIDE IN NATURE ADAM SMITHADAM SMITH

The chance of loss is by most men undervalued.The chance of loss is by most men undervalued. BENJAMIN GRAHAMBENJAMIN GRAHAM

Security of capital.Security of capital. WARREN BUFFETTWARREN BUFFETT

Harm or injury to purchasing power.Harm or injury to purchasing power. FINANCE THEORYFINANCE THEORY

Variance or standard deviation of past returnVariance or standard deviation of past return OCTOBER 1992OCTOBER 1992

Equities about to become much less risky?Equities about to become much less risky?

LOOK BEYOND LOOK BEYOND THE RECENT PASTTHE RECENT PAST

OFF THE RADAR SCREENOFF THE RADAR SCREEN

Our data didn’t go back far enoughOur data didn’t go back far enough BLACK SWANBLACK SWAN

It was an event that had never happened It was an event that had never happened before.before.

FIVE SIGMA EVENTFIVE SIGMA EVENT

No significant probability on our modelNo significant probability on our model

LOOK BEYOND THE RECENT PASTLOOK BEYOND THE RECENT PAST LONG-TERM CAPITAL MANAGEMENT 1998LONG-TERM CAPITAL MANAGEMENT 1998

Models did not go back to 1992 or 1987Models did not go back to 1992 or 1987 NORTHERN ROCK FSA COMMENT 2007NORTHERN ROCK FSA COMMENT 2007We had it as a low probability of getting into difficultyWe had it as a low probability of getting into difficulty ALLIANCE & LEICESTER COMMENT 2007ALLIANCE & LEICESTER COMMENT 2007

Our strategic review in 1999 underestimated correlationsOur strategic review in 1999 underestimated correlations ROYAL BANK OF SCOTLAND CHAIRMAN 2008ROYAL BANK OF SCOTLAND CHAIRMAN 2008

1 in 10,000 chances do turn up1 in 10,000 chances do turn up UBS COMMENT 2008 UBS COMMENT 2008

Crucial risk model based on favourable 5 year period Crucial risk model based on favourable 5 year period with low volatilitywith low volatility

WHICH BANK? WHICH YEAR?WHICH BANK? WHICH YEAR? Few directors had any real banking experience.Few directors had any real banking experience. Committed the cardinal banking sin of lending Committed the cardinal banking sin of lending

long-term against short-term borrowing in the long-term against short-term borrowing in the commercial money market.commercial money market.

Deputation to Bank of England to ask for loan.Deputation to Bank of England to ask for loan. CONTEMPORARY COMMENTCONTEMPORARY COMMENT

Universal loss of credit, endless suspicionsUniversal loss of credit, endless suspicions Need to check previous exorbitant level of Need to check previous exorbitant level of

available creditavailable credit

LOOK BEYOND LOOK BEYOND THE RECENT PASTTHE RECENT PAST

WINSTON CHURCHILLWINSTON CHURCHILLThe further you look back in history, the further you The further you look back in history, the further you

can look forward.can look forward. ADAM SMITHADAM SMITH

Restrictions on liberty of bankers necessary.Restrictions on liberty of bankers necessary. INSTITUTE OF ACTUARIESINSTITUTE OF ACTUARIES

Certum ex incertis – certainty out of uncertaintiesCertum ex incertis – certainty out of uncertainties FACULTY OF ACTUARIESFACULTY OF ACTUARIES

Ad finem fidelis – Faithful to the endAd finem fidelis – Faithful to the end

DEPARTURES FROM DEPARTURES FROM PRUDENT BEHAVIOURPRUDENT BEHAVIOUR

Large private equity deals on low interest ratesLarge private equity deals on low interest rates Covenant-lite corporate borrowingCovenant-lite corporate borrowing

Wall Street driving demand for sub-prime loansWall Street driving demand for sub-prime loans No reasonable margin on sub-prime loansNo reasonable margin on sub-prime loans

Mortgages of 5 times joint salariesMortgages of 5 times joint salaries 125% loan-to-value ratios125% loan-to-value ratios

£7.5m maximum mortgage – now £550,000£7.5m maximum mortgage – now £550,000

THERE IS NOTHING TO FEAR THERE IS NOTHING TO FEAR BUT FEARBUT FEAR

ADAM SMITH – HISTORY OF ASTRONOMYADAM SMITH – HISTORY OF ASTRONOMYPanic terrors always excited by the sudden onset of Panic terrors always excited by the sudden onset of

unexpected danger.unexpected danger. ALAN GREENSPAN – THE AGE OF TURBULENCEALAN GREENSPAN – THE AGE OF TURBULENCENormal rational behaviour impossible when fear exists.Normal rational behaviour impossible when fear exists.

Even investment bankers can be paralysed by fear.Even investment bankers can be paralysed by fear. US BANK TREASURER – SEPTEMBER 2007US BANK TREASURER – SEPTEMBER 2007

People are terrified of reputational damage.People are terrified of reputational damage.They know it could be a career-ending move.They know it could be a career-ending move.

US BANKER – SEPTEMBER 2007US BANKER – SEPTEMBER 2007Lending to anything east of a 212 local telephone code Lending to anything east of a 212 local telephone code

could be a terminal experience.could be a terminal experience.

EQUITIES, NOT BONDS OR EQUITIES, NOT BONDS OR CASH, FOR THE LONG RUNCASH, FOR THE LONG RUN

RISK ELEMENTRISK ELEMENTProportionate shortfall in real terms over given periodProportionate shortfall in real terms over given period

ORORSquare of proportionate shortfallSquare of proportionate shortfall

RISK VALUERISK VALUEAverage risk element over 100 year historyAverage risk element over 100 year history

UK EQUITIES AND LONG GILTSUK EQUITIES AND LONG GILTSEquities less risky over 4 years or longerEquities less risky over 4 years or longer EQUITY RISK PREMIUM PUZZLE?EQUITY RISK PREMIUM PUZZLE?

Myopic loss aversion, corrected by actuarial approachMyopic loss aversion, corrected by actuarial approach

INVESTMENT OF THE THIRD KIND INVESTMENT OF THE THIRD KIND NEW MONEY SEPTEMBER 2000NEW MONEY SEPTEMBER 2000

Billiton also rights issueBilliton also rights issue Rio TintoRio Tinto

Lloyds TSBLloyds TSB Standard CharteredStandard Chartered

ICI also rights issueICI also rights issue Rentokil InitialRentokil Initial

FTSE All-Share Index 40% fall to December 2002FTSE All-Share Index 40% fall to December 2002

September 2000 new money 4% fall to December 2002September 2000 new money 4% fall to December 2002

BEWARE OF RISING INFLATIONBEWARE OF RISING INFLATION 12TH MARCH 200812TH MARCH 2008

30TH MAY 2008 30TH MAY 2008

FINANCIAL TIMESFINANCIAL TIMES INSIGHT ARTICLEINSIGHT ARTICLE

Inflation cat jumps out of the bag to stalk Inflation cat jumps out of the bag to stalk credit markets.credit markets.

There is little useful history to predict what There is little useful history to predict what might happen to the corporate bond might happen to the corporate bond

market if inflation really does take hold.market if inflation really does take hold. MARKETSMARKETS

Bond yields hit high as inflation fears mount.Bond yields hit high as inflation fears mount.

THE POWER OF THE POWER OF DEVELOPING NATIONSDEVELOPING NATIONS Very rapid economic growthVery rapid economic growth Less restrictive legislationLess restrictive legislation

BUT danger of high inflationBUT danger of high inflation BUT poorer corporate governanceBUT poorer corporate governance

Sovereign wealth fundsSovereign wealth funds Strategic stakes in key industriesStrategic stakes in key industries

INVESTMENT OF THE THIRD KINDINVESTMENT OF THE THIRD KIND RISK SCREENRISK SCREEN

Inadmissible if significant fall in earningsInadmissible if significant fall in earnings MEDIUM TERM VALUE SCREENMEDIUM TERM VALUE SCREEN

Rank by utility function U = G – cRRank by utility function U = G – cR G 12 months consensus earnings growthG 12 months consensus earnings growth

R prospective price-earnings ratioR prospective price-earnings ratio C positive constant to disadvantage high RC positive constant to disadvantage high R

PORTFOLIO GUIDELINESPORTFOLIO GUIDELINES

4% in top 104% in top 10

3.5% in next 103.5% in next 10

2.5% in next 102.5% in next 10

Annual rebalancingAnnual rebalancing PERFORMANCE TRENDPERFORMANCE TREND

Around 5% p.a. out performance of FTSE All-Share IndexAround 5% p.a. out performance of FTSE All-Share Index

DECEMBER 2005 ASSESSMENTSDECEMBER 2005 ASSESSMENTS

FTSE 100 COMPANIESFTSE 100 COMPANIES

RankRank Company February 2006 Company February 2006 May May 20082008

11 BHP Billiton ! BHP Billiton ! 111 111 206 206

55 Man Group ! Man Group ! 109 109 194 194

66 Persimmon ? Persimmon ? 107 107 39 39

77 Northern Rock ?? 114 Northern Rock ?? 114 ? ?

FTSE All-Share IndexFTSE All-Share Index 103 103 109 109

DECEMBER 2005 ASSESSMENTSDECEMBER 2005 ASSESSMENTS FTSE 250 COMPANIESFTSE 250 COMPANIES

RankRank Company Company February 2006 May 2008 February 2006 May 2008 11 Venture Production ! Venture Production ! 123 123 157 15722 Vedanta Resources ! Vedanta Resources ! 115 115 291 2913 *Burren Energy !3 *Burren Energy ! 109 109 310 31044 Lonmin ! Lonmin ! 129 129 209 20955 Tullow Oil ! Tullow Oil ! 117 117 341 34166 Informa Informa 102 102 87 8777 William Hill William Hill 110 110 70 7088 Kensington Group ?? Kensington Group ?? 108 108 ? ?99 AmlinAmlin 96 96 116 1161010 Logica CMG Logica CMG 102 102 70 70 FTSE All-Share IndexFTSE All-Share Index 103 103 109 109

* Reinvested in ENRC December 2007* Reinvested in ENRC December 2007

INVESTMENT OF THE FOURTH KINDINVESTMENT OF THE FOURTH KIND RISK SCREENRISK SCREEN

Inadmissible if significant fall in earningsInadmissible if significant fall in earnings MEDIUM TERM VALUE SCREENMEDIUM TERM VALUE SCREEN

Require high value of U = G – cRRequire high value of U = G – cR LONG TERM VALUE SCREENLONG TERM VALUE SCREEN

Rank by 4-component long-term growth rate (LTGR)Rank by 4-component long-term growth rate (LTGR) PORTFOLIO GUIDELINESPORTFOLIO GUIDELINES

Highly unconventional – similar to Warren BuffettHighly unconventional – similar to Warren Buffett PERFORMANCE TRENDPERFORMANCE TREND

Around 10% p.a. out performance of FTSE All-Share Around 10% p.a. out performance of FTSE All-Share Index ?Index ?

PORTFOLIO GUIDELINESPORTFOLIO GUIDELINES Maximum investment 5% of current portfolio valueMaximum investment 5% of current portfolio value

Ignore sector weightingsIgnore sector weightings Do not sell unless overvalued in terms of U or Do not sell unless overvalued in terms of U or

LTGR deteriorates.LTGR deteriorates. Do not rebalance.Do not rebalance.

Switch if much more attractive opportunity availableSwitch if much more attractive opportunity available Eg: XSTRATAEg: XSTRATA

Cost 2.5% of May 2008 portfolio valueCost 2.5% of May 2008 portfolio value

Valuation 18% of May 2008 portfolio valueValuation 18% of May 2008 portfolio value

LONG TERM GROWTH RATELONG TERM GROWTH RATE

Volume growthVolume growth Size and stability of profit marginsSize and stability of profit margins

Ability to finance growthAbility to finance growth Operational flexibility in economic Operational flexibility in economic

downturndownturn Assess each component on scale of 1 to 7Assess each component on scale of 1 to 7

MAN GROUPMAN GROUPVOLUME GROWTHVOLUME GROWTH

Fast becoming the McDonald’s of Fast becoming the McDonald’s of alternative assetsalternative assets

Excellent performance of AHL Diversified Excellent performance of AHL Diversified fundfund

BUT poor Global Strategies performanceBUT poor Global Strategies performance Targeting individuals and institutions Targeting individuals and institutions

enriched by commodities boomenriched by commodities boom Good global retail networkGood global retail network

Still expanding unlike many competitorsStill expanding unlike many competitors

MAN GROUPMAN GROUPSIZE AND STABILITY OF PROFIT MARGINSSIZE AND STABILITY OF PROFIT MARGINS AHL costs investors 4% p.a.and 20% performance AHL costs investors 4% p.a.and 20% performance

feefee Elsewhere around 2% p.a. and 20%Elsewhere around 2% p.a. and 20%

No serious threat to high industry marginsNo serious threat to high industry margins ABILITY TO FINANCE GROWTHABILITY TO FINANCE GROWTH

Low expansion costs because of franchise natureLow expansion costs because of franchise nature $1.5bn cash to buy smaller rivals and hire talent$1.5bn cash to buy smaller rivals and hire talent

OPERATIONAL FLEXIBILITY IN ECONOMIC OPERATIONAL FLEXIBILITY IN ECONOMIC DOWNTURNDOWNTURN

AHL thrived in recent turbulenceAHL thrived in recent turbulence Demand for alternative assets increases in Demand for alternative assets increases in

difficult timesdifficult times More opportunities from tighter bank regulationMore opportunities from tighter bank regulation

2007 HEDGE FUND PERFORMANCE2007 HEDGE FUND PERFORMANCE CS TREMONT DATACS TREMONT DATA

SECTORSECTOR %%ALL HEDGE FUNDSALL HEDGE FUNDS 1212Multi-StrategyMulti-Strategy 1212Equity Market NeutralEquity Market Neutral 9 9Risk ArbitrageRisk Arbitrage 9 9

DistressedDistressed 8 8Dedicated Short BiasDedicated Short Bias 6 6

Managed FuturesManaged Futures 6 6Convertible ArbitrageConvertible Arbitrage 5 5

Fixed Income ArbitrageFixed Income Arbitrage 4 4

FTSE All-Share IndexFTSE All-Share Index 2 2

2007 HEDGE FUND PERFORMANCE2007 HEDGE FUND PERFORMANCE CS TREMONT DATACS TREMONT DATA

SECTORSECTOR %% Emerging MarketsEmerging Markets 20 20 Global MacroGlobal Macro 17 17 Event Driver Multi-strategy Event Driver Multi-strategy 17 17 Long/Short EquityLong/Short Equity 14 14 Event DrivenEvent Driven 13 13 ALL HEDGE FUNDSALL HEDGE FUNDS 12 12

FTSE All-Share IndexFTSE All-Share Index 2 2