Alpha Squared - Enhanced Hedge Fund Index Solution - Alpha Generation via Tactical Style Tilts.pdf by Q.M.S Advisors

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ALPHA2 ENHANCED HEDGE-FUND INDEX SOLUTION Alpha Generation via Tactical Hedge Fund Style Tilts Credit Suisse/Tremont investable hedge fund indices

GOAL § To maximize the risk-adjusted total return of a diversified portfolio of hedge fund sub-indices by actively overweighting and underweighting the components of the strategic portfolio KEY PRODUCT DIFFERENTIATING FACTORS § Innovative Solution: Alpha to be generated over and above Credit Suisse/Tremont investable hedge-fund index based on statistical evidence of the predictability in hedge fund sub-index returns § Transparent Quantitative Process: A disciplined approach based on robust quantitative processes from initial long-term derivation of longterm optimal weights to the derivation of tactical alpha tilts § Optimal Portfolio Construction: Equilibrium portfolio weights to be devised so as to meet investor’s objectives i.e. low correlation to traditional asset classes, maximum expected information ratio, low drawdown risks, or a combination of non-mutually exclusive objectives and constraints. § Market and economic intuition: Signals driving alpha tilts to be based on systematic risk factors, consistent with market and economic intuition THREE STEPS CONSTRUCTION PROCESS 1. Strategic Allocation: A disciplined and robust portfolio construction framework based on state-of-the-art risk quantification and management techniques a. Application of correction techniques to overcome biases associated with hedge fund sub-indices b. Non-linear dependence techniques to be applied to generate optimal equilibrium hedge fund basket weights (Rank Correlations, Copulas) c. Equilibrium portfolio allocations to be derived incorporating several predefined risk criteria and to be assessed with multiple methodologies (Reverse Mean-Variance optimization, Value at Risk (VaR) and modified VaR, Copula/Extreme Value Theory optimizations) d. Optimal allocation to include all predefined investor specifications and risk preferences

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Advisors 2. Tactical views and alpha generation: An innovative and transparent approach to focus on higher risk-adjusted opportunities a. Consistent incorporation of multiple dimensions of information including significant exogenous indicators and systematic risk factors b. Parsimonious number of signals are applied to all relevant sub hedge-fund indices c. Signalsâ&#x20AC;&#x2122; sensitivities to be dynamically adjusted according to their explanatory power d. Direction and confidence of resulting tactical views expressed in expected mean and standard error

3. Disciplined and robust portfolio construction framework a. Tactical views to be integrated at the final portfolio optimization step, where strategic and tactical views are to be apportioned according to model derived associated confidence levels b. Final optimization: To include all investor preferences (orthogonality to traditional asset classes, long-only and no leverage restrictions). c. Flexible control of position turnover via a transaction penalty parameter d. Risks associated with final solution to be consistent with following predefined bounds: maximum acceptable loss assessed via stresstests, VaR, mVaR, and EVT parameters

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Advisors OVERVIEW §

Initial objectives and constraints – The objective is to consistently out-perform the benchmark portfolio while staying within the prescribed risk limits – No short selling or leverage is permitted in the overall portfolio

Coverage includes CS/Tremont’s 10 main hedge fund indices: – CS/Tremont Convertible Arbitrage Index – CS/Tremont Dedicated Short Bias Index – CS/Tremont Emerging Market Index – CS/Tremont Equity Market Neutral Index – CS/Tremont Event Driven Index – CS/Tremont Fixed Income Arbitrage Index – CS/Tremont Global Macro Index – CS/Tremont Long/Short Equity Index – CS/Tremont Managed Futures Index – CS/Tremont Multi-Strategy Index

The ALPHA2 model selects from 95 exogenous signals: – Approach based on statistically sounds methodologies – Exogenous signals and systematic risk factors are consistent with market and economic intuition – Capability to expand the approach to additional hedge fund subsector indices

The ALPHA2 model offers an innovative and transparent approach to focus on profitable relative trades, allowing consistent incorporation of multiple dimensions of information advantage into the portfolio – At the individual hedge fund sub-sector strategy level: § A parsimonious number of signals are chosen § Weights of signals are dynamically adjusted § Direction and confidence of profitable investment views are derived – Across hedge fund sub-sector strategies: § Strategic equilibrium weights and tactical investment views are blended through a Bayesian framework based on their relative information advantage § Expected returns for all hedge fund sub-sectors are derived alongside their associated confidence levels – Portfolio construction: § Tactical over/under-weights are determined based on return and risk tradeoff, given the benchmark, constraints, turnover and transaction costs considerations

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Tactical shifts

Strategic allocation across hedge fund sub-indices

Identification of significant exogenous signals and systematic risk factors: Derive direction and confidence of investment views for all pairs Blending: Derive expected returns and risks for all hedge fund sub-indices

Portfolio construction and implementation: Tactical under/ over-weights

Further potential developments: – Tactical positions may be taken without regard benchmarks: maximizing risk-adjusted total return. – The portfolio may be leveraged.

any

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Advisors STATISTICAL RESULTS: All results are based on CS/Tremont Hedge Fund Sector Indices; backtested data from April 1994 to July 2007

Fig1: Benchmark Composition â&#x20AC;&#x201C; Static Hedge Fund Sector Weights

CS/Tremont Convertible Arbitrage 13%

CS/Tremont MultiStrategy CS/Tremont Managed 15% Futures 3% CS/Tremont Long/Short Equity 8%

CS/Tremont Dedicated Short Bias 0% CS/Tremont Emerging Markets 3% CS/Tremont Equity Market Neutral 23%

CS/Tremont Global Macro 9% CS/Tremont Fixed Income Arbitrage 12%

CS/Tremont Event Driven 14%

Fig2: Portfolio Composition â&#x20AC;&#x201C; Alpha2 Hedge Fund Sector Rotation Model Weights 100.0% 90.0%

70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0%

CS/Tremont Equity Market Neutral CS/Tremont Managed Futures CS/Tremont Long/Short Equity CS/Tremont Fixed Income Arbitrage CS/Tremont Dedicated Short Bias

May-07

May-06

May-05

May-04

May-03

May-02

May-01

May-00

May-99

May-98

May-97

May-96

May-95

0.0% May-94

Dynamic Weights across HF Sectors (in%)

80.0%

CS/Tremont Global Macro CS/Tremont Multi-Strategy CS/Tremont Event Driven CS/Tremont Emerging Markets CS/Tremont Convertible Arbitrage

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Fig3: Historical Realized Risk-Return trade-off

14.00% Alpha2 HF Sector Rotation Model

Realized Returns (in % p.a)

13.00%

CS/Tremont Investable Hedge Fund Index

12.00%

11.00%

10.00%

Benchmark - Static HF Sector Weights CS/Tremont MultiStrategy

9.00%

8.00% 3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

Realized Risks (in % p.a)

Fig4: Growth of $100M since Inception and Maximum Drawdown

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$600

0.00%

$500

-1.00% $523.09 -2.00%

$400

-3.00% $368.14 -4.00%

$300 -5.00% $200

-6.00% -7.00%

$100

Maximum Drawdown (in %)

Growth of $100M

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-8.00% May-07

May-06

May-05

May-04

May-03

May-02

May-01

May-00

May-99

May-98

May-97

May-96

May-95

-9.00% May-94

Alpha2 HF Sector Rotation Model - Growth Static HF Sector Weights - Growth Alpha2 HF Sector Rotation Model - Drawdown Static HF Sector Weights - Drawdown

9% 8% 7% 6% 5% 4% 3% 2% 1%

-2%

May-07

May-06

May-05

May-04

May-03

May-02

May-01

May-00

May-99

May-98

May-97

May-96

-1%

May-95

0% May-94

12-Monh Rolling Alpha and Tracking Error to the Static HF Sector Weights Benchmark

Fig5: 12-Month Rolling Alpha and Tracking Error to the Static HF Sector Weights Benchmark

Alpha2 HF Sector Rotation Model - 12Mo Rolling Alpha Alpha2 HF Sector Rotation Model - 12Mo Rolling Tracking Error

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Advisors 2

Alpha HF Sector Rotation Model

Benchmark Static HF Sector Weights

CS/Tremont MultiStrategy

CS/Tremont Hedge Fund Index

13.30% 4.16% 3.20 0.39 4.62 21.53

10.34% 3.50% 2.96 -0.77 7.88 173.33

9.67% 4.22% 2.29 -1.31 6.83 142.81

11.78% 7.27% 1.62 -0.01 6.12 64.31

-3.39% -1.12% -0.33% 0.84% 2.11% 2.32% 2.96%

-4.70% -1.68% -1.27% 0.85% 3.17% 4.85% 6.75%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

-1.36% -1.72% -0.64% -0.39% -0.30% -0.21% 0.89% 0.82% 2.47% 1.94% 3.16% 2.45% 4.40% 3.24% Realized Returns (in % p.a.) 3.13% -0.52% 12.73% 13.53% 22.05% 18.20% 23.19% 17.46% 6.60% 1.42% 23.49% 16.48% 11.74% 10.96% 7.97% 8.77% 10.07% 5.75% 15.80% 13.35% 9.78% 7.87% 9.35% 5.61% 14.26% 12.93% 7.76% 6.77%

-5.60% 11.72% 13.92% 18.11% 7.45% 9.25% 11.05% 5.46% 6.27% 14.93% 7.48% 7.43% 14.39% 7.99%

3.98% 21.22% 21.38% 25.19% -1.08% 22.73% 4.32% 4.38% 3.00% 15.31% 9.55% 7.51% 13.69% 8.62%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Realized Risks (in % p.a.) 2.84% 1.25% 2.59% 2.60% 4.10% 3.02% 5.89% 4.40% 6.05% 7.07% 6.76% 3.61% 3.66% 3.37% 2.41% 1.83% 2.58% 1.74% 3.25% 2.07% 2.64% 2.21% 3.41% 2.92% 3.60% 2.84% 2.56% 2.31%

9.37% 4.45% 3.34% 2.67% 6.30% 4.35% 4.00% 2.20% 2.44% 2.24% 2.43% 4.04% 3.34% 3.00%

4.84% 7.17% 10.83% 9.22% 12.47% 9.40% 10.49% 2.26% 2.77% 2.59% 3.38% 3.96% 4.35% 2.71%

Based on CS/Tremont Hedge Fund Indices' Historical Data from May 1994 to July 2007 Return Risk Return/Risk Ratio Skewness Kurtosis Test: Jarque-Bera 1st Percentile 5th Percentile 10th Percentile Median 90th Percentile 95th Percentile 99th Percentile