An Introduction to

Alternative Investments

how non-tr a ditiona l str ategies m ay

benefit portfolio performance

S a f e H a r b o r a n d F o r wa r d - L o o k i n g S t a t e m e n t s D i s c l o s u r e

The opinions expressed in this report are subject to change without rates, the impact of developing world events, and other factors that may
notice. This material has been prepared or is distributed solely for infor- influence the future performance of the illustrative examples. Hatteras
mational purposes and is not a solicitation or an offer to buy any security believes these forward-looking statements to be reasonable, although
or instrument or to participate in any trading strategy. The opinions they are inherently uncertain and difficult to predict. Actual events may
discussed are solely those of Hatteras and may contain certain forward- cause adjustments in portfolio management strategies from those cur-
looking statements about the factors that may affect the performance of rently expected to be employed. It is intended solely for the use of the
the illustrative examples in the future. These statements are based on person to whom it is given and may not be reproduced or dis­t ributed to
Hatteras’ predictions and expectations concerning certain future events any other person. The information and statistics in this report are from
and their expected impact, such as performance of the economy as a sources believed to be reliable, but are not warranted by Hatteras to be
whole and of specific industry sectors, changes in the levels of interest accurate or complete. Past performance does not guarantee future results.
I n troduct ion  

I f you are reading this paper, you likely already have

some knowledge of alternative investments. You
may be interested in learning more about a subject
strategies that utilize trading techniques generally
unavailable through public markets. These strategies
include hedge funds, private equity, real estate, natu-
that is both broad and extremely detailed. You may ral resources, managed futures, and others typically
have heard that college endowments and institutions offered only to sophisticated (knowledgeable) institu-
have been using hedge funds, private equity, and real tional and private investors. (Please reference the
estate with great success over the years. You may have appendix of this document for a discussion on specific
also seen headlines about hedge funds that have alternative investment strategies.) These strategies are
“blown up.” Much of what you’ve heard or read has usually structured as private partnerships and are not
some truth, but needs to be clarified and placed into typically governed by the regulations placed on tradi-
context to be fully understood. This paper will intro- tional investments. This offers alternative investment
duce you to alternative investments: the advantages, managers freedom to operate in a variety of markets
potential risks, and which vehicles may be appropriate and employ a broad range of investment strategies that
for various situations. Alternative investments, also are not available to traditional equity or fixed income
called non-traditional investments, are investment portfolio managers.

­ h at A r e t h e Obj ect i v e s of A lter nat i v e

W
I n v e stm en ts?

A lt e r nat i v e investment managers have a

greater range of strategies available, but what
does that ultimately mean for the investor? Why have
answer is that adding alternatives to a portfolio of
traditional assets can help lower risk while potentially
enhancing returns. More specifically, alternative
colleges, institutions, and high net worth individuals investments offer the following:
chosen to allocate assets to these strategies? The basic

• Increased Diversification • Portfolio Performance

• Lower Correlations • Access to Talent
• Lower Portfolio Volatility

Incr eased Di v ersification

A lt hough farmers, parents, and even investors

have long understood the warning, “Don’t put
all your eggs in one basket,” Harry Markowitz actu-
management. Markowitz showed that combining
assets which do not exhibit a high correlation to one
another gives investors an opportunity to reduce risk
ally won the Nobel Prize for his work that quantified without sacrificing return.1
and explained this adage as it relates to portfolio

1 Diversification does not guarantee a profit or protect against a loss in declining financial markets.

1
 T he measurement of a diversified portfolio’s risk is
not simply the weighted average of the individual
volatility measurements. Instead, a diversified port­
For years, investors have attempted to create diver­
sified portfolios by combining stocks with bonds
and cash. Investors have sought further diversification
folio exhibits less risk than the weighted average of its by allo­cating capital to domestic and international
underly­ing positions’ individual risks. In Pioneering stocks, growth and value stocks, and stocks of dif­
Portfolio Manage­ment, David Swensen, CIO of Yale ferent capitalization ranges and different sectors.
University’s endowment, summarizes Markowitz’s Unfortunately, these efforts do not combine assets
Nobel Prize-winning theory: “By combining assets that move independently of one another—one of
that vary in response to forces that drive markets, Markowitz’s requirements in constructing a diver­
more efficient portfolios provide higher returns sified portfolio. Investors with capital allocated to
than less well diversified portfolios. Conversely, various regions, sectors, and capitalization ranges are
through appro­priate diversification, a given level of not necessarily getting the efficiency associated with
returns can be achieved at lower risk.”2 a truly diversified portfolio. Chart 1 illustrates the
high correlation of differ­ent equity indices in times of
crisis over the past twenty years.

Through appropriate diversification, a given level of

returns can be achieved at lower risk.

Chart 1:

Sept. 2001
Oct. 1987 September 11th
Black Monday Terrorist Attacks
Aug. 1990 to
Sept. 1990
Onset of Gulf War Dec. 2007 to
Feb. 2009
Global Financial
Mar. 2000 to Crisis
Oct. 2002
Bear Market

The above information is hypothetical and is meant as an illustration only. Unmanaged indices are for illustrative purposes only. An investor cannot invest directly in an
index. Index performance does not reflect the deduction of fund fees and charges. Past performance is no guarantee of future results.
2 Swensen, David F., Pioneering Portfolio Management. The Free Press, New York, NY, 2000. page 62.
2
I n v e s t or s seeking portfolio diversification may
utilize fixed income in an effort to help reduce the
risk associated with equities. Historically, fixed
“By identifying high-return asset classes, not highly
correlated with domestic marketable securities, inves-
tors achieve diversification without the opportunity
income has not correlated highly with equities, costs of investing in fixed income. Possibilities for
therefore offering diversification benefits. However, a institutions include real estate, venture capital, lever-
significant performance trade-off is associated with aged buyouts, oil and gas participations and absolute
bonds and cash. A portfolio which includes both return strategies. If these asset classes provide high
traditional and nontraditional investment strategies equity-like returns in a pattern that differs from the
offers increased diversification and the opportunity return pattern of the core asset (U.S. domestic equi-
for better returns (versus using fixed income as the ties), investors create portfolios that offer both high
portfolio’s sole diversifier). Summing up the diversifi- returns and diversification. Although on an asset-
cation benefits associated with alternative invest- specific basis, higher expected returns come with the
ments, Swensen offered: price of higher expected volatility, diversification pro-
vides investors with a mechanism to control risk.”3

L ow er C or r el ations  

I n order for diversification to realize its benefits, a

portfolio’s underlying asset classes must behave
differently in varying market conditions. The mea-
another or to traditional asset classes. Many alterna-
tive investment strategies are designed to help reduce
the role of overall market direction in determining
surement of this historical relationship, whether dif- return. These strategies isolate a manager’s investment
ferent or similar in behavior, is called correlation. thesis and talent, decreasing the likelihood of signifi-
A correlation coefficient of 1.0 indicates that two cant correlation to general market indices such as the
investments behave exactly the same—moving in the S&P 500 Index. Describing the ability of alternative
same direction with the same amplitude—in varying investments to produce returns regardless of market
market conditions. A –1.0 correlation coefficient indi- direction, a study by BARRA RogersCasey concluded,
cates that two assets will move inversely in lockstep. “While traditional investments derive the majority of
investment return from the capital markets, many
Adding alternative investments to a portfolio can help hedge fund strategies are less affected by the direction
increase diversification because, for the most part, of underlying capital markets.”4
alternative strategies are not highly correlated to one

3 Swensen, David F., Pioneering Portfolio Management. The Free Press, New York, NY, 2000. pgs. 66–67.
4 BARRA RogersCasey. 2001. “An Introduction to Hedge Funds.” The first in the BRC Hedge Fund Series, 16.
3
 A lt e r n at i v e investment strategies (as repre-
sented by the respective indices in Chart 2) do
not exhibit a strong correlation toward one another
investors the opportunity to create a truly diversified
portfolio. If an investor’s goal is to secure higher
returns at a lower level of risk, then adding alternative
or toward traditional asset classes. The lack of correla- investments to the traditional portfolio is an attrac­
tion between alternative investment strategies offers tive option.

HFRI Eurekahedge HFRX Cambridge S&P Goldman BarCap Russell S&P 500
Chart 2 Equity Fixed Absolute PE7 Citigroup Sachs Agg 2000
Correlation Coefficient Hedge Income5 Return
Index6
World
Property
Commodity
Index
Bond

(Jan. 1990–Dec. 2010)

HFRI Equity Hedge 1.00 0.59 0.56 0.71 0.51 0.20 –0.12 0.80 0.79
Eurekahedge Fixed Income5 0.59 1.00 0.56 0.33 0.56 0.03 0.10 0.64 0.52
HFRX Absolute Return6 0.56 0.56 1.00 0.39 0.28 0.18 –0.02 0.40 0.37
Cambridge PE7 0.71 0.33 0.39 1.00 0.47 0.18 –0.20 0.64 0.71
S&P Citigroup World Property 0.51 0.56 0.28 0.47 1.00 0.12 0.12 0.66 0.65
Goldman Sachs Commodity Index 0.20 0.03 0.18 0.18 0.12 1.00 –0.18 –0.03 0.00
BarCap Agg Bond –0.12 0.10 –0.02 –0.20 0.12 –0.18 1.00 –0.15 –0.06
Russell 2000 0.80 0.64 0.40 0.64 0.66 –0.03 –0.15 1.00 0.88
S&P 500 0.79 0.52 0.37 0.71 0.65 0.00 –0.06 0.88 1.00

Source: Calculations by Hatteras Funds.

L o w e r P o r t f o l i o Vo l a t i l i t y

B y adding alternative investments to the tradi-

tional portfolio, an investor can reduce portfolio
volatility and improve the opportunity to experience
Barclays Capital U.S. Aggregate Bond Index. The table
also shows the Sharpe ratio and the Sortino ratio for
each asset class, which measure the return produced
increased returns over the long term. Beyond their by an investment (above the risk-free rate) per unit of
ability to reduce risk as portfolio diversifiers, many risk taken. The Sharpe measures return over any type
alternative strategies exhibit very low volatility when of volatility, whereas the Sortino measures return over
considered in isolation. downside volatility only. Each alternative index exhib-
its lower risk, as represented by standard deviation,
Chart 3 compares the risk and return of various alter- versus equities. Each alternative index exhibits higher
native investment classes (as represented by the Sharpe and Sortino ratios versus both equities and
respective indices) to the S&P 500 Index and the fixed income.

Chart 3
Risk Table Annualized Annualized Standard Sharpe Sortino
(Jan. 1990–Dec. 2010) ROR Deviation8 5.00%9 5.00%10
HFRI Equity Hedge 14.02% 9.20% 1.03 1.73
Eurekahedge Fixed Income5 10.56% 3.87% 1.46 2.70
HFRX Absolute Return6 8.10% 4.03% 0.79 1.22
S&P Citigroup World Property 2.15% 18.76% –0.05 –0.07
S&P 500 8.52% 15.21% 0.32 0.44
BarCap Agg Bond 6.99% 3.82% 0.82 1.33

The above information is hypothetical and is meant as an illustration only. Unmanaged indices are for illustrative purposes only. An investor cannot invest directly in an
index. Index performance does not reflect the deduction of fund fees and charges. Past performance is no guarantee of future results.
  5 Eurekahedge Fixed Income launched 1/1/2000 so preceding period uses HFRI RV Fixed Income-Corporate Index.
  6 T he inception date of the HFRX Absolute Return Index is 4/1/2003. Index values provided prior to the inception dates listed above were calculated by means of
retroactive application of the index model. Prior to 1998, the HFRI Relative Value (Total) Index was used as a benchmark.
  7 Data through 3Q10.
  8 Standard deviation is a measurement of the investment’s volatility.
  9 T he Sharpe ratio is a risk-adjusted measure of return that divides a portfolio’s return in excess of the risk-free rate by the portfolio’s standard deviation. Over this time
period, the risk-free rate was assumed to be a constant of 5%.
10 T he Sortino ratio is the excess return over the risk-free rate divided by the downside semi-variance—in other words, it measures return divided by an asset’s negative or
“bad” volatility. As in the Sharpe ratio, the risk-free rate is assumed to be 5%.
4
H o w N o n -T r a d i t i o n a l S t r a t e g i e s B e n e f i t P o r t f o l i o P e r f o r m a n c e

F or years, endowments have enjoyed the benefits

of lower volatility in their portfolios. How does
reduced volatility help investors? Reducing the fre-
How valuable is lower portfolio volatility to an inves-
tor? A $1,000 investment in the S&P 500 Index from
1950 through 2010 would have produced an average
quency and severity of losses in a portfolio creates an return of 8.70% with a standard deviation of 16.80%.11
environment in which the portfolio may compound At the end of that period, the $1,000 investment would
returns more efficiently. When an investor experi- have grown to $73,152. (That actually sounds fairly
ences negative returns in a volatile portfolio, subse- enticing.) However, if the investor could have utilized
quent monthly returns must first “catch up” for those instruments that allowed him to earn the same [aver-
prior losses before the investor can begin to enjoy age] return (8.70%) with half the volatility (8.40%), his
growth on his initial investment. When an investor $1,000 investment would have grown to $134,093.
experiences consistently positive returns in a low vola- Lowering portfolio volatility by half created 83% more
tility portfolio, each month’s returns compound upon in additional wealth.12
prior positive returns to offer growth and help pre-
serve capital. The true power of compounding has its
greatest impact when negative months are eliminated
or their severity is significantly reduced.

Chart 4
Large Endowments Focus on Consistent Compounding

Growth of $1,000
$150,000
$134,093
$125,000 $73,152

$100,000

$75,000

$50,000

$25,000

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

From 1950 to 2010, the average annual return of the S&P 500 has been 8.70%, with a standard deviation of 16.80%.11
Over that time period, an investment with the same return but half the volatility creates 83% more wealth.12

The above information is hypothetical and is meant as an illustration only. Unmanaged indices are for illustrative purposes only. An investor cannot invest directly in an
index. Index performance does not reflect the deduction of fund fees and charges. Past performance is no guarantee of future results.
11 Source: Standard & Poor’s.
12 Source: Morgan Creek Capital Management.

5
 An efficient frontier maps the possible risk and return Between January 1990 and December 2010, the 60/40
relationships of a combination of asset classes over traditional portfolio generated a return of approximately
a chosen time period. In Chart 5, the solid line rep- 8.2% with a standard deviation of approximately 10.0%.
resents a continuum of asset allocations to the
S&P 500 and Barclays Capital U.S. Aggregate Bond
Index. Moving from left to right (“northeast”) on the
B e t we e n Ja n u a r y 19 9 0
graph, the portfolios allocate incrementally more
assets to equities while fewer to bonds. A point on a n d D e c e m b e r 2 01 0 , t h e
the line represents a discrete portfolio with a specific
allocation towards stocks and bonds. For any point on 6 0 /4 0 t r a d i t i o n a l p o r t f o l i o
the line, there is a measure of both return and risk
generated a retur n of
(both are dependent upon the time series chosen). For
example, the triangle located on the bold line repre- approximately 8.2%.
sents a typical 60% equity/40% fixed income portfolio.

Chart 5: Efficient Frontier—Including Allocation to Alternatives (Jan. 1990–Dec. 2010)

9.5%

S&P 500
Total Return Index
8.5% HFRI Fund of Funds
Composite Index 60/40 Portfolio
Annualized Returns (%)

7.5%
Historically,
allocating towards
BarCap U.S. FoF decreases risk.
Aggregate Bond Index
6.5%

5.5%
3% 5% 7% 9% 11% 13% 15% 17%
Annualized Standard Deviation13
Source: Pertrac Financial Solutions

Past performance is not an indication of future results. Index returns are provided for illustrative purposes only to demonstrate the use of diversification among asset classes
using broad-based indices of securities. Returns do not represent an actual investment. Actual returns would vary. Indices do not have costs, fees, or other expenses associ-
ated with their performance. Therefore, actual investment returns would be lower. In addition, securities held in an index may not be similar to securities held in an actual
account. It is not possible to invest directly in an index.
13 Standard Deviation is a measurement of the investment’s volatility.
6
Using the HFRI (Hedge Fund Research, Inc.) Fund affect a portfolio: “Alternative asset classes—absolute
of Funds Index as a simplified proxy of alternative return, real estate, and private equity—contribute to
investments, an additional efficient frontier was cre- the portfolio construction process by pushing back
ated (shown as the dashed line in Chart 5). This new the efficient frontier, allowing the creation of port­
efficient frontier includes stocks (S&P 500 Total folios with higher returns for a given level of risk
Return), bonds (Barclays Capital U.S. Aggregate Bond or lower risk for a given level of returns. Investors
Index), and alternative investments (as represented treating alternative assets as legitimate tools in the
by the HFRI Fund of Funds Composite Index). Any portfolio allocation process reduce dependence on
chosen point along the new efficient frontier line rep- traditional marketable securities, facilitating the
resents a discreet portfolio that allocates to some com- structuring of truly diversified portfolios.”14
bination of stocks, bonds, and alternative investments.
With the x-axis as volatility and the y-axis as return,
an investor would like a portfolio positioned in the
upper left segment of the graph: high returns with In a por t folio context,
low standard deviation over time. The dashed arrow
indicates the direction and approximate risk/return you can see that allocating
characteristics that could be expected as an investor
assets to alternative
allocates assets toward alternatives and away from the
traditional 60/40 portfolio. In a portfolio context, you investments could increase
can see that allocating assets to alternative invest-
ments could potentially increase return and reduce return and reduce risk.
risk. Swensen describes how alternative investments

Ac c e s s t o Ta l e n t

I nvestment professionals gravitate to this sector in

large part because compensation is based on ability
as demonstrated by returns, not merely the firm’s abil-
Many would consider incentive fees the most sig­
nificant reason that these talented professionals are
leaving traditional investment management shops.
ity to gather assets under management.15 Sometimes However, the manager’s ability to generate a return to
referred to as the “brain drain,” talented investment earn an incentive fee is, at least partially, dependent
managers leave traditional equity and fixed income upon the other three points. When a highly motivated
funds for hedge funds, private equity funds, or other manager can combine his expertise with the freedom
types of alternative investment funds where they can to utilize an appropriate set of tools, he is more likely
potentially benefit from: to generate the returns that investors expect. Because
• Incentive compensation of the aligned interests associated with incentive fees,
both sides are happy.
• Greater breadth of investment instruments
and strategies
• Privacy of investment ideas associated with
less transparency
• The ability to capitalize on the benefits of
taking less liquid positions

14 Swensen, David F., Pioneering Portfolio Management. The Free Press, New York, NY, 2000. pg. 204.
15 McKean, Paul F., CFA, “Absolute-Return Strategies” from proceedings of AIMR (Association for Investment Management and Research) CFA Continuing Education
seminar, 1998. pg. 50.
7
 Wh at A r e t h e R isk s of A lter nat i v e I n v e stm en ts?
• Lack of Regulation • Fraud
• Lack of Transparency • Manager Selection Risk
• Inappropriate Use of Leverage

L ack of R egu l ation

W h i l e traditional managers are subject to fed-

eral regulation, alternative investment manag-
ers are subject to far less regulation under U.S. federal
the aftermath of their actions create headlines that are
far more interesting than news of an ethical manager
who produces gains legally.
securities laws. Hedge funds and private equity invest-
ments escape these regulations because alternative
investments are private placements, meaning that they
are able to take accredited and qualified investors Without governmental
without registering with the Securities and Exchange
or agency regulation
Commission. These investors have been determined
by government and regulatory agencies to have and oversight, private
enough capital to withstand loss and are generally
thought of as sophisticated investors that are able to investors must themselves
understand the risks of private investments. Without
focus significant resources
governmental or agency regulation and oversight, pri-
vate investors must themselves focus significant on due diligence.
resources on due diligence.

Alternative investment managers benefit from the

flexibility afforded by the lack of regulation. Such Some managers register their funds under the Invest­
flexibility allows alternative managers to utilize lever- ment Company Acts of 1940 and/or 1933. A registered
age and use short selling techniques to hedge market fund will disclose its holdings to the public and to
exposures, and affords the opportunity to protect shareholders at least every six months.
information in less stringent transparency require-
ment. However, this also makes it possible for some
investment managers to benefit from unethical acts
that cheat investors. Reports of these criminals and

8
L ac k o f Tr a n s pa r e n c y

T r a n spa r e nc y describes the amount of port-

folio information that is provided to investors
or potential investors. Portfolio transparency is vari-
Although managers have long protected their port­
folios from public eyes, significant strides have been
made toward finding an appropriate balance of dis­
able, ranging from full to non-existent. Full trans­ closure. Funds of funds, consultants, and even third
parency provides details that facilitate an investor’s party risk management providers have prompted
ability to analyze the underlying investment thesis, advances in the provision of greater leniency regard-
style, risk, and leverage. However, transparency is ing portfolio “look-throughs.”
neither required nor commonplace among alternative
investments. Without full transparency, investors must depend
upon the due diligence process to understand a man-
Reduced transparency protects a fund manager’s ideas ager’s process and portfolio objectives. A lack of trans-
from competitors. This issue is especially noticeable in parency can also be considered a benefit to current
hedge funds that utilize short investing techniques, as investors, as protection at the portfolio level reduces
investment managers need to protect their positions potential threats from non-investors.
from others who could take adversarial positions
designed to “squeeze” (artificially inflating the price
of) a portfolio’s short positions.

Ina ppropr i ate Use of Lev er age

L e v e r age means using borrowed funds for the

pursuit of investment opportunities. Leverage
magnifies an investment manager’s performance; that
Leverage is typically used at the individual fund level;
for example, in a specific hedge fund. However, some
funds of funds now utilize leverage to amplify the
magnification can be good or bad. Leverage has been overall fund’s performance. It is important for inves-
associated with several “blow ups” in the hedge fund tors to ask individual funds and funds of funds to
industry, most notably Long Term Capital Manage­ explain their aggregate level of leverage and how its
ment in 1998. Leverage, like shorting, is simply a tool use is appropriate for that specific strategy. Investors
that alternative investment managers may use. Some should use care in their utilization of leverage,
use leverage appropriately, applying conservative lev- protecting a portfolio from levels of risk that are not
els to positions that exhibit moderate volatility. Some appropriate. Leverage is not inherently bad. It is a
managers have applied excessive leverage to vehicles portfolio management tool that can be used appropri-
that exhibit significant volatility. ately or inappropriately.

9
 Fr au d

F raud is one of the most difficult investment risks

to protect against. In the past ten years, investors
have experienced terrible losses in the traditional
must understand all disclosures and then address any
questions that were not answered in fund provided
documents. An investor must conduct quantitative
investment arena through acts of fraud conducted by analysis to determine whether a fund’s historical risk
management at WorldCom, Enron, and Tyco (all pub- and return were plausible and explainable. Does a
licly listed regulated companies). Fraud may happen manager really have a seven year track record or is
in alternative investments also. Although it is ques- that record based on a back-tested model? Does the
tionable whether Bernie Madoff’s Ponzi scheme was answer give you comfort with the manager? An
even a hedge fund, the media has assigned its terrible important precaution against potential fraud is exten-
repercussions to the hedge fund industry. Before sive use of background checks. While most managers
Bernie, Sam Israel III and Associates defrauded their will provide a list of professional and client references,
investors at Bayou Hedge Fund Group in 2005. use of industry contacts and even professional private
investigators can increase an investor’s ability to learn
To combat potential fraud, investors must conduct sig- about a manager’s past. An in-person on-site inter-
nificant due diligence by asking questions that speci­ view should enable investors to cover any unanswered
fically target a manager’s ethics, experience, track questions and determine whether it is appealing to do
record, and utilization of investment and business risk business with a specific person or group. Lastly, investors
controls. The due diligence process can offer answers must conduct this type of in-depth due diligence on a
that give investors comfort and confidence. An investor continual basis after the investment has been made.

M anager Selection R isk

C u r r e n t ly , investors cannot allocate capital to

alternative strategy indices; therefore, active
investment managers must be chosen. How does an Does an investor have
investor pick a manager? How can he know that he
has found the best convertible arbitrage manager or
the time, experience,
the best long/short manager? Does an investor have
resources, and access to
the time, experience, resources, and access to reliable
data necessary to make a confident choice? reliable data necessary to
One significant problem associated with choosing make a confident choice?
alternative investment managers is the large disparity
among individual manager returns. The return differ-
ence between the best managers and the worst manag-
ers in a specific alternative investment strategy is p e o p l e : Consider education, experience, cohesion,
typically much greater than the return disparity responsibilities, turnover, compensation and special skills.
between the best and worst traditional investment p h i l o s o p h y : Evaluate investment strategy, con-
managers. This puts greater pressure on an investor to sistency, trading, client service and risk management.
find the best manager within a particular strategy.
p r o c e s s : Learn how the firm’s investment philoso-
phy is implemented.
Manager selection risk encompasses many of the
potential pitfalls associated with choosing an invest- p e r f o r m a n c e : Assess attribution, calculation,
ment partner. To mitigate manager selection risk, consistency, repeatability, volatility, and dispersion
investors must address each of the following: among accounts.16

16 Yoder, J. (1998). “A Primer on Alternative Investments: Free Lunches, Magic, and the Four Ps,” Business Officer, 36(2), 21-25.
10
How Do I n v e stor s Acce s s A lter nat i v e s?
• Individual Single Strategy Managers • Fund of Funds

I n di v i dua l Si ngl e St r at egy M a nager s

I n v e st or s can allocate capital to individual hedge

funds, private equity funds, or real estate funds.
Depending upon an investor’s size, sophistication,
investors, adding two hedge funds and a venture capi-
tal fund to their portfolios is simply an opportunistic
foray into an exciting asset class. Unfortunately, those
resources, and access to research, this can be an appro- investors cannot achieve portfolio diversification and
priate way to allocate portfolio assets to alternative risk reduction by simply taking a “random walk”
investments. Alternative investment managers typi- through the universe of alternative investment strate-
cally have investment minimums of $1 million to $5 gies and managers.
million. Therefore, in order to achieve an appropriate
level of diversification across strategies and managers,
an investor would need to employ at least $25 million.
That figure assumes that the investor is able to find Some investors have the
25 managers who maintain a $1 million investment
minimum and who are open to new investors. That expertise and resources
scenario does not take into account the additional
costs associated with creating such a portfolio—such in-house to make these
as paying an internal staff to conduct research and d e c i s i o n s (i n d i v i d u a l ,
analysis, opportunity costs associated with the inves-
tor’s time, or the cost of fees paid to outsourced s i n g l e s t r a t e g y m a n a g e r s)
professionals. If the investor also maintains that risk
management is important, he will need to invest ...other investors assume
between $50–200 thousand in a third party risk man- that they do, but find
agement system.
out later that they were
Some investors, such as large state pension funds, have
the expertise and resources in-house to make these mistaken.
decisions and implement the ongoing “portfolio man-
agement” processes necessary to successfully manage
direct allocations to alternative strategies. Other inves-
tors assume that they do, but find out later that they Allocating assets across a portfolio of individual
were mistaken. investment managers should be left to the largest,
most sophisticated investors who can achieve an
Some investors are not interested in crafting a diver­ appropriate level of diversification with an efficient
sified portfolio of alternatives to complement the use of capital. Investors can benefit from guidance
traditional portfolio. These investors will direct their and experience when they consider these asset classes.
limited resources toward finding 2–3 very good indi-
vidual alternative investment managers. For those

11
 Fund of Funds

A fund of funds is a professionally managed invest-

ment vehicle that allocates investor capital toward
multiple underlying managers. Some funds of funds
An investor must do as much due diligence on a fund
of funds as on an individual investment manager. An
investor should seek a fund of funds with an invest-
utilize a multi-strategy, multi-manager approach, ment objective that is aligned with his own portfolio
allocating capital across several investment strategies. investment objectives. Investors should seek expe­
Other funds of funds allocate capital to multiple rienced and ethical management teams who have
managers within a single strategy, such as long/short demonstrated advantages within the strategy that
investment strategies. they manage.

Funds of funds create target allocations designed to Detractors will cite that funds of funds maintain an
achieve an investment objective. Fund managers then extra layer of fees, above those of the individual funds.
make allocation decisions, overweighting or under- They do. An investor is paying for the experienced
weighting certain strategies or managers in an effort guidance, resources, risk management, access to tal-
to increase the likelihood that the fund’s objectives ent, and daily fund management that a fund of funds
are met. offers. If a fund of funds reports its performance net
of all fees—meaning net of all management and incen-
A fund of funds typically has an investment minimum tive fees at both the individual fund level and at the
in the $1–10 million range. An investment offers fund of funds level—then the investor can determine
immediate diversified access to multiple strategies whether or not that fund’s return and risk characteris-
and managers. The number of managers underlying a tics are worth paying for.
fund of funds will differ, but typically is between 20
and 80.

C onclusion

A l l alternative investment strategies are not the

same. Investors should carefully research and
understand how adding specific strategies—alone or
are not governed by the same level of regulation as
traditional investments, alternative investment man-
agers have access to a broader array of investment
in combination with other strategies—will affect a tools and opportunities.
portfolio’s return and risk characteristics. An investor
should ensure that an alternative investment strategy’s When considered as a complement to traditional
objective is congruent with his. assets, prudently selected alternative investment strat-
egies can potentially reduce risk and enhance return
Considered in isolation, alternative investment strate- for the overall portfolio. Adding alternative invest-
gies are attractive because they are designed to pro- ment strategies to a portfolio of traditional assets can
duce positive returns, with low standard deviation. help increase diversi­f ication and help to potentially
Alternative investment strategies are often managed lower volatility, offering an opportunity to compound
by talented, experienced investment managers who positive returns and avoid significant periods of loss.
are compelled to achieve fund objectives through However, it should also be noted that diversification
incentive compensation. Because alternative investments does not guarantee a profit or protection against loss.

12
A ppen di x
• Strategies Explained • Real Estate
• Absolute Return • Private Equity

Speci fic A lt e r nat i v e I n v e stm e n t St r at e gi e s E x pl a i n e d

A lt e r n at i v e investments can be organized

into two primary categories: Hedge Funds and
Private Strategies. Absolute Return, Real Estate and
fewer diversification benefits because returns can be
influenced by the same factors that drive public equity
market returns. Broadly speaking, any alternative
some National Resources Strategies generally provide investment strategy can be categorized as either a risk
excellent diversification benefits because the strategies reducer (diversifier) or a return enhancer.
employed do not rely heavily upon market direction
for returns. Opportunistic Equity and Private Equity Below is a graphic representation of the different sub-
have the potential to generate strong returns, but have classes of alternative investments:

Alternative Investment Strategies

Hedge Fund Strategies Private Strategies

Opportunistic Enhanced Absolute Private Energy & Natural

Real Estate
Equity Fixed Income Return Equity Resources

Long/Short Distressed Equity Market Long/Short Early Stage Long/Short

Equity Securities Neutral REIT Venture Energy

Global/Emerging Convertible Real Estate Late Stage Exploration

Global Macro
Market Debt Arbitrage Partnerships Venture & Production

Structured Fixed Income Growth Midstream

Short Equity Infrastructure
Credit Arbitrage Capital Energy

Long/Short Statistical Services &

Long/Short Credit PIPEs
Speciality Arbitrage Technology

Long/Short Leveraged
Event Driven Buyouts Commodities
International Loans

Loan Managed
Distressed
Origination Futures

Secondaries

13
 Absolute Return

T h rough hedge funds, which allow techniques

such as “short selling” and leverage, absolute
return investors seek to generate positive returns that
Event driven investing seeks to generate returns based
on correctly anticipating corporate finance trans­
actions such as mergers and the reorganizations
are independent of the overall market. Absolute return associated with bankruptcies. The success of these
managers build portfolios comprised of “inefficiency- investments is determined by the arbitrageur’s ability
exploiting marketable securities positions exhibiting to correctly assess the pending transaction’s pricing,
little or no correlation to traditional stock and bond timing, and ultimate conclusion. For example, when a
investments.”17 Absolute return investments can be merger is announced, an event driven investor can
sub-categorized: Relative Value, Event Driven, buy the target company’s stock and sell stock of the
Opportunistic, and Managed Futures. The risks asso- acquiring company. The investor seeks to profit from
ciated with these investments are lack of liquidity, the typical price spread compression that occurs as
volatility and loss of investment value. the merger’s conclusion approaches. Profits are event-
dependent instead of market driven. Opportunistic
Relative value investing depends upon a manager’s investing is a broad grouping of different strategies
talent in recognizing both undervalued and overval- and techniques that all have the similar trait of allow-
ued securities. Traditional long-only equity managers ing the investment manager to seize an advantage in
seek to profit from finding companies whose value knowledge, research, temporary pricing anomalies, or
increases over time (“buy low, sell high”). Selling short market-specific inefficiencies to generate profit. One
is a technique that allows an investor to sell the stock example of an opportunistic investor is the macro
of an overvalued company today, with an agreement investor, who uses a top-down approach to predict
to buy back the shares at a lower price in the future how macroeconomic and geopolitical events will affect
(“sell high, buy low”). pricing relationships. Macro investors are able to use a
broad range of strategies across a broad range of
A relative value manager will employ both long and regions with the simple mandate of finding and tak-
short investments, seeking to profit from successfully ing advantage of pricing discrepancies.
predicting one company’s future value relative to
another related company’s future value (or decline in Managed futures traders manage portfolios of futures
value)—regardless of the direction of the overall mar- contracts with the goal of profiting from movement in
ket. For example, a relative value investor could buy the prices of commodities, currencies, energy, and
shares of an undervalued beverage company and sell stock and bond indices. Managed futures investors
short the shares of an overvalued beverage company seek profits in varying economic conditions—including
in an effort to profit from successfully assessing the down markets—by creating portfolios of non-
value relationship between the two companies within correlated commodities diversified across regions,
the same sector. Regardless of whether beverage stocks countries, and economies. A diversified portfolio of
are up or down, returns are driven by talent in deter- futures contracts is not correlated historically to tradi-
mining valuation. tional markets.

17 Swensen, David F., Pioneering Portfolio Management. The Free Press, New York, NY, 2000. pg. 205.
14
R ea l E state

R e a l estate investments are unique in that they

exhibit the characteristics of both debt and
equity investments. Cash f lows from leases resem-
private real estate is valued periodically by appraisal
until it is sold (which is the only true valuation point).
REITs have offered higher returns than private real
ble the income that bond holders receive from coupon estate over time, but have exhibited higher standard
payments. Real estate also possesses equity-like char- deviation as well. While REITs possess higher volatil-
acteristics associated with variable property values. ity and a stronger correlation to stocks than private
Some real estate holdings also offer an element of real estate, some investment managers take both
protection from unanticipated inflation. long and short positions in REITs to reduce market
exposure—while enjoying the liquidity associated
Real estate investments can be public, in the form with publicly marketable securities. The risks associ-
of REITs (Real Estate Investment Trusts), or private. ated with real estate investing include lack of liquidity,
Stock-market traded REITs are valued daily, while volatility and loss of investment value.

P r i va t e E q u i t y

P r i vat e equity investments made through lev­

eraged buyouts, venture capital, and mezzanine
debt have the potential for high returns, but also
their stake in a business at attractive multiples; how-
ever, the reality is that not all business ideas—no matter
how carefully researched—succeed. If two out of ten
exhibit higher standard deviation versus other alter- investments are “home runs,” a venture fund is likely
native asset classes. The volatility of these strategies to reward its investors with attractive returns.
is due in part to the operational risk associated with
the underlying investments and in part to a greater Leveraged buyout firms borrow money to take control
sensitivity to the forces that drive the public equity of target companies whose potential value can be
markets. Most private equity strategies exhibit some unlocked through operational changes. Buyout spe-
degree of illiquidity and possess a potential for higher cialists seek mature businesses with real revenue and
returns and higher volatility. predictable cash flow that can be used to pay off the
debt used to purchase them. The ultimate goal of an
Venture investors offer early-stage capital in exchange LBO is to sell the company once it is more profitable.
for significant ownership stake in a private company. The time horizon on these types of investments is sig-
Venture capital investment funds seek to diversify nificantly longer, requiring a “lock up” of investor
their investments across several types of businesses, capital. The risks associated with investing in private
regions, management teams and especially over dif- equity include lack of liquidity, volatility and loss of
ferent time periods. Venture managers seek to sell investment value.

15
 I m p o r t a n t I n f o r m a t i o n : Hedge funds are 6) Derivative Instruments: risks are volatility, illiquid-
speculative investments and are not suitable for all ity and substantial loss of money beyond initial
investors, nor do they represent a complete invest­ investment;
ment program. The Funds are only open to qualified 7) Investment in non-U.S. securities: risks are illiquid-
investors who are comfortable with the substantial ity, currency fluctuations, lack of transparent man-
risks associated with investing in hedge funds. The agement and geopolitical;
Funds investment program is speculative and entails 8) “Junk” bonds and illiquid investments: loss of
substantial risks. Specific risks associated with under- money, inability to sell securities, legal issues, cor-
lying securities that populate the Hedge Funds in porate malfeasance, bankruptcy proceedings and
which the Funds invest include: volatility otherwise not associated with bonds.

1) R isks inherent in an investment in securities: loss of Investors should recognize that they will bear asset-
money, illiquidity, volatility; based fees and expenses at the fund level, and indi-
2) Specific risks associated with limited liquidity: rectly, fees, expenses and performance-based
underlying securities may not be available to sell for compensation of the investment funds in which these
long periods of time thus limiting exit strategies Funds invest. In addition, the overall performance of a
and redemptions; fund of funds is dependent not only on the investment
3) The use of leverage: leverage compounds returns by performance of individual managers, but also on the
adding exposure which can enhance performance ability of the fund’s Advisor to allocate the fund’s
but also exacerbate losses; assets amongst such managers on an ongoing basis.
4) Short Sales: risks are illiquidity, use of leverage and Investors should understand that they will likely be
unlimited loss potential; required to obtain extensions of the filing date for
5) Options & Futures: risks are volatility, illiquidity their income tax returns due to possible K-1 delays.
and substantial loss of money beyond initial Investors could lose some or all of their investments.
investment;

Index Definitions by U.S. leveraged buyout, subordinated debt, and spe-

cial situation managers. Cambridge Associates, LLC
60/40 Portfolio calculates the pooled net time-weighted return by
60% S&P / 40% Barclays Capital U.S. Aggregate quarter. The pooled means represent the time-
Bond Index. weighted rates of return calculated on the aggregate of
all cash flows and market values as reported by the
Barclays Capital U.S. Aggregate Bond Index general partners to Cambridge Associates. Net returns
The Index represents securities that are SEC-registered, exclude all management fees, expenses, and perfor-
taxable, and dollar denominated. It covers the U.S. mance fees that take the form of a carried interest.
investment grade fixed rate bond market, with index
components for government and corporate securities, Eurekahedge Fixed Income Index
mortgage pass-through securities, and asset-backed Please contact Eurekahedge at www.eurekahedge.com
securities. These major sectors are subdivided into for more information on the methodology of this index.
more specific indices that are calculated and reported HFRI Equity Hedge Index
on a regular basis. Funds included in the Index include investment man-
Cambridge Associates U.S. Private Equity Index agers who maintain positions both long and short in
The Index is based on returns data compiled on funds primarily equity and equity derivative securities. A
representing more than 70% of the total dollars raised wide variety of investment processes can be employed
16
to arrive at an investment decision, including both Portugal, Singapore, Spain, Sweden, Switzerland, and
quantitative and fundamental techniques; strategies the United Kingdom. Most international mutual funds
can be broadly diversified or narrowly focused on measure their performance against this index. It is a
specific sectors and can range broadly in terms of market-capitalization weighted index.
levels of net exposure, leverage employed, holding
NASDAQ
period, concentrations of market capitalizations, and
The Index measures all NASDAQ domestic and inter-
valuation ranges of typical portfolios. Equity hedge
national based common type stocks listed on The
managers would typically maintain at least 50%, and
NASDAQ Stock Market. It includes nearly 3,000
may in some cases be substantially invested in equities,
companies. Launched in 1971 with a base value of 100
both long and short.
points, the NASDAQ Composite Index is a broad
HFRI Fund of Funds Composite Index based index which is calculated under a market capi-
Funds included in the Index invest with multiple talization weighted methodology.
managers through funds or managed accounts. The
Russell 2000 Index
strategy designs a diversified portfolio of managers
The index measures the performance of the 2,000
with the objective of significantly lowering the risk
smallest companies in the Russell 3000 Index, which
(volatility) of investing with an individual manager.
is made up of 3,000 of the biggest U.S. stocks. The
The fund of funds manager has discretion in choosing
Russell 2000 serves as a benchmark for small cap
which strategies to invest in for the portfolio. A man-
stocks in the United States.
ager may allocate funds to numerous managers within
a single strategy, or with numerous managers in mul- Standard & Poor’s (S&P) 500 Index
tiple strategies. The minimum investment in a fund of The index of 500 stocks chosen for market size, liquid-
funds may be lower than an investment in an indi- ity, and industry grouping, among other factors. The
vidual hedge fund or managed account. The investor S&P 500 is designed to be a leading indicator of U.S.
has the advantage of diversification among managers equities and is meant to reflect the risk/return charac-
and styles with significantly less capital than investing teristics of the large cap universe. Companies included
with separate managers. in the index are selected by the S&P Index Committee,
a team of analysts and economists at Standard &
HFRX Absolute Return Index
Poor’s. The S&P 500 is a market value weighted index
The Index is designed to be representative of the overall
—each stock’s weight in the index is proportionate to
composition of the hedge fund universe. It is com-
its market value.
prised of all eligible hedge fund strategies, including
but not limited to convertible arbitrage, distressed Standard & Poor’s (S&P) Citigroup World
securities, equity hedge, equity market neutral, event Property Index
driven, macro, merger arbitrage, and relative value The Index represents the full global universe of insti-
arbitrage. As a component of the optimization pro- tutionally investable property stocks, with a consistent
cess, the Index selects constituents which characteris- methodology across all regions. It includes more than
tically exhibit lower volatilities and lower correlations 450 constituents from 23 developed markets, and pro-
to standard directional benchmarks of equity market vides investors with a comprehensive benchmark that
and hedge fund industry performance. can be used for active or passive management.
MSCI EAFE Index The Standard & Poor’s (S&P) Goldman Sachs
The Morgan Stanley Capital International Europe, Commodity Index (GSCI)
Australia, Far East Index is a benchmark of foreign The Index provides investors with a reliable and pub-
stocks. Compiled by Morgan Stanley, the Index is an licly available benchmark for investment performance
aggregate of 21 individual country indices that collec- in the commodity markets. It is designed to be trad-
tively represent many of the major markets of the able, readily accessible to market participants, and
world, including: Australia, Austria, Belgium, Denmark, cost-efficient to implement. The Index is widely rec-
Finland, France, Germany, Greece, Hong Kong, Ireland, ognized as the leading measure of general commodity
Italy, Japan, the Netherlands, New Zealand, Norway, price movements and inflation in the world economy.
 8540 Colonnade Center Drive, Suite 401 Tel 866.388.6292 www.hatterasfunds.com
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