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Alternative Investment Solutions

Contents

Hedge fund industry characteristics size, shape and implications risk, return and correlation role within a traditional portfolio

Fund industry analysis basic strategy classifications and return sources drivers of opportunity and risk enhanced strategy classifications

Research philosophy strategy research example

Contents (Continued)

Investment process strategy clusters, operational due diligence cluster, asset

allocation cluster and risk management cluster

Client related topics mandate discussions issues surrounding transparency post 1998 environment regulatory environment industry maturation expectations and tolerances

Conclusion

Growth of the industryThe Hedge Fund industry continues to grow as more investors allocate to the asset class

Source: Hedge Fund Research, Inc.

$38,190$58,370$95,720

$256,720

$817,492

$889,838 (E)

$536,060

$622,304

$185,750

$487,580$456,430$456,430

$374,770$367,560

$167,790

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

$800,000

$900,000

$1,000,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

AS

SETS

(U

SD

MIL

LIO

N)

ESTIMATED ASSETS NET NEW MONEY PER ANNUM

GROWTH OF HEDGE FUNDS (1990 - 2004)

$8,463$27,861

$36,918($1,141)

$14.698$57,407

$91,431$4,406

$54,847$20,353

$46,544$99,436

$75,084

$46,588

As of Q3

Trading15%

Relative Value24%

Equity Hedge42%

Event Driven19%

Hedge fund industryHedge Funds capital flows are dynamic, and require an understanding of strategies

COMPOSITION IN 1990 COMPOSITION IN 2004

Source: Hedge Fund Research Source: Hedge Fund Research

Raffaldini ppt.xls*Pies?Chart 2


Trading74%

Equity8%

Event Driven

7%

Relative Value11%


Hedge funds in a traditional portfolioWhilst effect of adding hedge funds is to increase return in long-term, emphasis is placed on reducing volatility, due to hedge funds’ lack of correlation with traditional investments

ANNUALISED RISK RETURN CHART (JANUARY 1990 - DECEMBER 2003 INCLUSIVE)

Source: Bloomberg, Hedge Fund Research Inc.

Correlation of HFRI Fund of Funds Index- to MSCI World: 0.42- to JP Morgan Global Bond Index: -0.07- to 50% MSCI World, 50% JPM GBI: 0.34

11%

EQUITIESMSCI World Equity Index

(r = 4.40%, v = 14.96%)5%

6%

7%

8%

9%

10%

2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17%

VOLATILITY

CO

MP

OU

ND

AN

NU

AL

RE

TU

RN

4%

BONDS

JP MorganGlobal Bond Index

(r = 8.01%, v = 6.28%)

BLENDED PORTFOLIO50% JPM GBI

50% MSCI World(r = 6.50%, v = 8.63%)

HEDGE FUNDSHedge Fund Research Inc.

Fund of Funds Index (r = 10.28%, v = 5.75%)

BLENDED PORTFOLIOWITH HEDGE FUNDS

40% JPM GBI40% MSCI World

20% HFRI FoF Index (r = 7.31%, v = 7.37%)

Upside participation and loss avoidanceHedge funds seek to preserve capital during down months for equities while attempting to benefit from some of the gain in up months

PERFORMANCE COMPARISON OF THE HFRI FUND OF FUNDS INDEX DURING POSITIVE AND NEGATIVE MONTHS OF THE MSCI WORLD EQUITY INDEX JANUARY 1990 - DECEMBER 2003

Average monthly return during 70 negative months for MSCI

World

-3.59%

3.34%

0.10%

1.35%

(5.00%)

(4.00%)

(3.00%)

(2.00%)

(1.00%)

0.00%

1.00%

2.00%

3.00%

4.00%

MSCI World HFRI Fund of Funds Index

Average monthly return during 98 positive months for

MSCI World


Risk control in stress marketsReduction in volatility is achieved because hedge funds typically hedge against market risk

SEPTEMBER 2001 RETURNS

0%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

-20%

-18%

-16%

HFRI Fundof Funds

Index

S&P 500Index

NASDAQ

Russell 2000Index

MSCIWorld


Consistent performanceExcess return in hedge funds during this period is achieved not by out-performing in good years, but by preserving capital in bad years, resulting in much lower volatility

17.5%14.5%

12.3%

26.3%

-3.5%

11.1%14.4% 16.2%

-5.1%

26.5%

4.1% 2.8%1.0%

11.5%

(30%)

(20%)

(10%)

0%

10%

20%

30%

40%

S1

ANNUAL RETURNS OF MSCI WORLD AND HFRI FUND OF FUNDS INDICES JAN 1990 TO DEC 2003

AN

NU

AL

RE

TU

RN

(%

)

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003


HFRI Fund of Funds Index (10.3% p.a. return, 5.8% volatility) MSCI World (4.4% p.a. return, 15.0% volatility)

How is this achieved?

Risk control is absolutely paramount. The emphasis is on capital preservation, with loss defined as loss of capital, not under-performance of a benchmark

The key to understanding this is to appreciate the compensation schedule for a hedge fund manager: a management fee, usually around 1% an incentive profit fee, usually around 20% of net new high profits

The compensation schedule has a profound affect in avoiding loss thereby creating a non-symmetrical risk-return distribution

Furthermore, unlike relative return (benchmark managers), hedge funds seek to produce absolute return

In the event that market conditions are difficult, they can simply raise cash and reduce exposure unlike traditional strategies

Loss avoidance is everything

Basic classificationsThe hedge fund industry has developed a diverse set of strategies and styles to generate returns

Event Driven

Relative Value

Equity Hedged

Trading

Company-specific research (Information)

Liquidity provision (Risk premia)

Merger and Credit arbitrage spreads (Risk premia)

Price Pattern (Behavior)

Drivers of risk and return

Hedge funds attempt to create returns through Capturing market risk premia Exploiting market inefficiencies

Risk premium exists to compensate participants for assuming risk due to uncertainty

Markets are inefficient, generally in small ways in many places Information Market structure Liquidity Behavior

Skilled operations with the proper tools may take advantage of the opportunities

Strategy classificationsImportance to delineate into the sub-strategy level given differing sources of risk and return drivers

Note: These are the strategy groupings used by Alternative Investment Solutions

Fixed Income Arbitrage

Statistical Arbitrage

Convertible Bond Arbitrage

Volatility Arbitrage

Fundamental Conservative

Fundamental Aggressive

Fundamental Short Bias

Event Equity

Opportunistic Trading

Systematic Long / Short

Merger Arbitrage

Credit Long / Short

Distressed / High Yield

Multi-Strategy

Other RV / ED

EQUITY HEDGED

TRADING

RELATIVE VALUE / EVENT DRIVEN

Systematic

Discretionary Global Macro

Discretionary Specialized

Emerging Markets

Research platformIndependent research platform integrates strategy (top-down) and manager (bottom-up) analyses

MANAGERRESEARCH

MANAGERRESEARCH

STRATEGY RESEARCH

Investment process

Manager Approval Committee1

Agrees upon a recommended list of managers for portfolios

Investment Committees

Constructs portfolios based on specific risk and return targets as it relates to the portfolio mandate

StrategyClusters

Undertakes research that generates

recommendations on managers within

context of peer group

Operational Due Diligence Cluster

Evaluates the various non-

investment related risks

Asset Allocation Cluster

Generates recommendations

on portfolio structure

Risk Management Cluster

Ensures risks within portfolios are understood, intended and compensated

Notes:1 Does not make portfolio-specific decisions

Strategy Cluster

Research is underpinned by an in-depth understanding of strategy drivers and manager differentiation

Clusters allow global participation and coordination of research effort, with resources allocated along “like skill sets” grouping of strategies

Thorough and efficient research designed to provide forward-assessment of manager risk and return expectations

Objective: Undertakes research that generates recommendations on managers within context of peer group

Follow-up meetings

Initial Meeting

STRATEGY RESEARCH

Responsibilities of the Strategy Clusters

SOURCING

PRIORITIZING

Continuous review of dynamic factors underlying each strategy’s risk and opportunity set

Organize prospects in order of importance

Establish general overview

Gain comprehensive understanding

Compare managers against industry peers on risk and performance measures

MANAGER RESEARCHManagers allocated to a lead SIO and/or IO

Identify potential new managers

Sponsored by CIO or SIO

StrategyClusters

Ops. Due Diligence Cluster



On-going manager monitoring to generate buy, hold or sell recommendation

PEER ANALYSIS

MANAGER MONITORING

MANAGER RECOMMENDATIONS

Manager Approval

Committee

Investment Committee

Operational Due Diligence Cluster

Determine whether existing infrastructure enables the manager to focus on generating returns

Assess the scalability of the operations relative to the strategies employed

Establish a channel of communication between Alternative Investment Solutions and the hedge fund back office operations

Establish an understanding of information and timelines expected

Key points include:Objective: evaluates the various non-investment related risks

StrategyClusters




Manager Approval

Committee


Responsibilities of the Operational Due Diligence Cluster

RECEIVE FUND OVERVIEWReceives overview of the manager from respective strategy cluster

Instigate independent UBS security checks

IO’s generate and submit a report to the Manager Approval Committee

Meet senior members of the manager’s logistics teams

DUE DILIGENCE QUESTIONNAIRE

Send questionnaire to manager and review once returned

Regular monitoring and discussions with the manager

StrategyClusters




Manager Approval

Committee


SECURITY CHECKS

MANAGER MEETING

REPORT GENERATION

MONITORING

Manager Approval Committee

Draws on the output from the Strategy and Operational Due Diligence Clusters

Committee comprises the Senior Investment Officers of the group and is chaired by CIO

Committee meets formally on a monthly basis Discusses and debates occur informally on an intra-month basis

Managers are approved by a two thirds majority where a quorum is defined as a minimum of four voting members

The Committee also determines managers to be removed from the recommended list

Objective: agrees a recommended list of managers for portfolios

StrategyClusters




Manager Approval

Committee



Iterative approach considering manager availability, strategy research and macro-economic views

Recommendations on strategy allocation framework based on economic considerations, strategy developments and risk

Rather than rely solely on traditional mean variance optimization, strategy recommendations also utilize other quantitative techniques This avoids problems inherent in historical modeling that occur

when faced with non-predictive factors

Objective: generates recommendations on portfolio structure

StrategyClusters




Manager Approval

Committee


MACRO ENVIRONMENT

Responsibilities of the Asset Allocation Cluster

STRATEGY OPPORTUNITIES

RISK/REWARD ANALYSIS

ASSET ALLOCATION RECOMMENDATION

Qualitative assessment of strategy opportunity set

Assess global macro economic trends

Estimate risk/reward for each strategy

Develop asset allocation recommendation for each unique mandate

StrategyClusters




Manager Approval

Committee



Assesses the balance of risk and reward within the portfolio in both normal and stress market conditions

Relevant risk factors are gathered in order to analyze fund performance and risk at both manager and portfolio level

Qualitative and quantitative analysis increases the robustness of the portfolio construction process

Objective: ensures risks within portfolios are understood, intended and compensated

StrategyClusters




Manager Approval

Committee


QUANTITATIVE MANAGER REVIEW

Responsibilities of the Risk Management Cluster

QUANTITATIVE PORTFOLIO REVIEW

RISK ASSESSMENT

SCENARIO/STRESS ANALYSIS

Performance-based analysis of portfolio risks, and the relation between investments

Analytical decomposition of fund performance

Aggregate components of manager risk and at the portfolio level

Multifactor models to explain performance in normal and stress environments

StrategyClusters




Manager Approval

Committee


RISK LIMIT OVERSIGHTContinuously monitoring of actual versus targets, benchmarks and peers

PORTFOLIO RECOMMENDATIONS

Quantitative recommendations regarding incremental portfolio risk of an investment

Mandate discussion

Establish expectations for return, risk and correlation (both for normal market environments and stress)

Client constraints are established, examples include strategy exposure types of managers manager concentration

Controlling risk is much easier than controlling return Alternative Investment Solutions considers itself a risk manager

that manages a portfolio rather than a portfolio manager that manages risk

Issues surrounding transparency

Question comes down to risk measurement versus risk management Hedge fund managers generally reluctant to provide full disclosure given

that other market participants can use this information to their advantage particularly relevant when short positions, controversial and illiquid securities

are involved

What level of disclosure is necessary to perform effective and pro-active investment monitoring? Is position level reporting as useful as costs associated with it or the

negative selection bias it can create? Importance of relevant risk factors, value-at-risk analysis, stress tests,

position concentration and “Greeks” that are unique to each fund strategy and sub-strategy

detail analysis without the disclosure of sensitive information

The role of pro-active forward looking qualitative monitoring should NOT be underestimated

There are many views on the feasibility and importance of total transparency

Post 1998 environment

How has the hedge fund industry changed since 1998? Increased appreciation of dangers of excessive leverage and strategies that

overly rely on it for profit (i.e. certain types of fixed income arbitrage trades) there has been a large outflow of assets from hedge funds that use these

approaches

Limitations of value-at-risk in event of major systemic shock (the ‘one in a hundred year’ scenario) and increased usefulness in stress testing portfolios

importance of understanding the shifting risks to both a single hedge fund manager and a portfolio during normal and shock market environments

Outcome has been a general decline in leverage across wide variety of strategies as evidenced by lower stress losses in 9/11

In addition, various global regulatory authorities are beginning to dedicate more time and resources to analyzing the hedge fund industry and their role within the financial markets

Aftermath since LTCM

Regulatory environment Trading areas

Particular analysis is on relationship between research and trading within the sell side community and as it relates to hedge funds

Rules to restrict or increase the difficulty of short selling would have negative effect on hedge funds: not only are shorts alpha generating (bad companies with bad business models that are failing) but also are exposure reducing (like pair trading)

Non-trading areas In the US, the source of funds (Patriot Act requirements) SEC Hedge Fund Act Registration (as opposed to Regulation) is

an important underpinning for investor confidence

Markets/countries that have placed restrictions on hedge fund activities have seen liquidity levels and traditional investor interest decline sharply

Greater Oversight

Industry maturation

Recent asset inflows into hedge funds have been strong Nevertheless, hedge funds account for less than 6% of total market

value of traditional long-only world of all financial assets It is important to understand not just the absolute level of inflows but

also to which strategies the inflows are going large inflows currently going to strategies that need additional capital such

as credit derivatives and other evolving new markets

Hedge fund performance is cyclical and profitable arbitrage situations ebb and flow Certain strategies tend to be counter-cyclical to each other (like merger

arbitrage and distressed credit), namely a diminished opportunity set in one strategy frequently leads to improving profit potential in the other

Hence, importance of a broad based portfolio to capture the changing opportunity sets of various strategies

Is there a hedge fund bubble?

Expectations and tolerances

Risk free interest rate + alpha + beta Libor is a good proxy for the level of interest rates Alpha is the ability to profit from either hedge fund manager

selection (selection effect) and strategy allocation (allocation affect). These typically average around 6% net a year

Beta is the intended and unintended market movement of a portfolio. Since broad based fund of funds portfolios function as a diversifier, over time the beta can average around 0.20 to an index like the S&P 500

Setting these before investing is important

Expectations and tolerances (cont’d)

Given this equation, when fund of funds generated an annual return of 14% in the late 1990s, it was composed of an average Libor of 6%, 6% in alpha and 2% in beta (.20 beta * 10% average gain in the S&P 500)

In 2002 the performance for most fund of funds was 3%, with Libor at 2%, 6% in alpha and -5% beta (.20 beta * -25% loss in S&P)

All of this should be accomplished with an annualized volatility between 3% to 5%, a worse monthly loss between 1% to 2% and generating profitability 75% to 80% of all months

Setting these before investing is important

Allocation Issues

The decision to invest in hedge funds frequently comes down to two choices – invest directly or through a fund of fund Investing directly avoids an additional layer of fees but introduces issues

surrounding manager selection issues (access and return dispersion) and manager monitoring issues (disclosure and resources)

Investing in a fund of fund product avoids this issues but comes with an additional layer of fees

A common approach is to initially invest in a broad based fund of fund product then, over time and as experienced is gained, direct investments are made to multi-strategy single hedge funds This model is frequently referred to as ‘core-satellite’, with the fund of

funds representing the core 75% to 80% allocation while the satellite direct investments make up the balance

The ultimate decision is as unique as the individual plan sponsors business model and needs

Conclusion

Broad based hedge fund portfolios belong in any investment portfolio due to the unique role they perform when combined with traditional asset classes Non-correlated sources of alpha benefit any portfolio, and should

always be incorporated, no matter what their source (hedge funds, real estate, private equity, timber etc)

Opportunities will continue to exist The ability to perform regulatory arbitrage and lock up money is a key

component in capturing alpha Existing financial markets will inevitably grow in tandem with real

economies and new strategies develop to exploit dislocations

Given these factors, the most logical question is not whether to invest or not but what are the appropriate allocation levels to make to a traditional portfolio

Alternative Investment Solutions prepared the information, including but not limited the charts and graphs, contained within this presentation. Unless otherwise noted, the information used to create these charts and graphs was based solely on information collected and retained in Alternative Investment Solutions’ proprietary database and is accurate as of the date so indicated on the particular chart or graph. Third party funds and managers contributed to the majority of the information collected; therefore, Alternative Investment Solutions makes no representations as to the accuracy of such source information and the charts and graphs are subject to change without notice to the recipient. As such, the charts and graphs do not purport to be a scientific or academic analysis; but rather, represent some measure of support for the experientially based opinions of Alternative Investment Solutions. This document does not constitute an offer of securities. Such an offer will only be made by means of a confidential offering memorandum. This material is confidential and intended solely for the information of the person to whom it as been delivered. Recipients may not reproduce or transmit it, in whole or in part, to third parties.Past performance is not indicative of future results and future results may differ significantly from current or historical returns.

This document has been issued through UBS O’Connor Limited for distribution to Intermediate or Market Counterparty customers and through UBS Global Asset Management (US) Inc. UBS O’Connor Limited (authorized and regulated by the Financial Services Authority in the UK) and UBS Global Asset Management (US) Inc. (a member of NASD and SIPC) are subsidiaries of UBS AG.

Disclaimer

Contact information

AmericasRoy Freeman* +1-203-719 5419 [email protected] Murphy* +1-312-525 5133 [email protected]

UK, Europe & Middle East (ex Switzerland) Tim Sweeting +44-20-7901 5835 [email protected] Fischerstrom +44-20-7901 5819 [email protected]

Japan/KoreaYukio Nagamoto +81-3-5208 7657 [email protected] Ueno +81-3-5208 7405 [email protected]

Switzerland

René Steiner +41-1-239 33 35 [email protected]

Asia PacificHoward Knight +65-6836 5465 [email protected] Tallboys +852-2971 8225 [email protected] Theresa Han +852-2971 8832 [email protected]

Wealth ManagementPatrick Casparis (Europe) +41-1-239 18 96 [email protected] Sinn (Hong Kong) +852-2971 8806 [email protected] Zhao (Singapore) +65-6836 5462 [email protected] Plaisance (Americas) +1-203-719 1506 [email protected]

Enhanced Index

Tiziana Holmgren +1-203-719 6223 [email protected]

* Registered representatives of UBS Global Asset Management (US) Inc.

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