DRAFT TL-RR Hedge Funds

DRAFT TL-RR Hedge Funds

RESEARCH REPORT

The Commerce Trust Company Research Group – 2016

Hedge Funds The term “hedge fund” represents a myriad of unique strategies and asset classes. At Commerce Trust, we believe that incorporating the right mix of hedge fund strategies into a traditional portfolio can lower overall volatility and protect portfolio assets. Hedge fund strategies can exhibit very low correlations to stocks and/ or bonds (see table), and they can generate positive portfolio returns even when both of these asset classes decline. In this paper, we aim to broadly define the most common hedge fund strategies and make the case for employing hedge funds as part of an alternative investment allocation because of their potential diversification effects in a balanced portfolio.

INSIDE:

What Are Hedge Funds? Hedge Fund Legal Structures Strategy Descriptions

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WHAT ARE HEDGE FUNDS? Hedge funds are actively managed strategies that can use advanced investment techniques such as leverage, short positions, derivatives, arbitrage, swaps, and others in order to attain returns that are not directly correlated to the movements of the stock or bond markets. Hedge funds can invest in the equity, fixed income, commodity, and/or currency markets, but they typically attempt to deliver return streams that have very low correlations to these asset classes. Often, they also have the goal of generating returns that are positive in all market cycles (called an “absolute return”) and/or outperforming a specific market benchmark.

Role in a Portfolio The Importance of Due Diligence Conclusion

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COMMON HEDGE FUND TERMS LEVERAGE: Enhancing returns through borrowing or other techniques. LONG POSITIONS: Purchasing securities that the fund manager believes will increase in value. SHORT POSITIONS: Selling securities not currently owned that the fund manager believes will decrease in value. DERIVATIVES: Investments tied to other securities that provide certain exposures, typically with a fraction of the underlying assets otherwise required. ARBITRAGE: Purchasing one security and shorting another security that is tied to the first. This can produce a positive return without the underlying exposure to the market and often is employed with leverage. SWAPS: Gaining or shedding certain exposures through derivative contracts. FUTURES CONTRACTS: A contractual agreement to buy or sell a particular commodity or financial instrument at a predetermined price in the future.

HEDGE FUND STRATEGIES MONTHLY CORRELATIONS

(01/1996–12/2015)

BLOOMBERG BARCLAYS AGGREGATE BONDS INDEX

S&P 500 INDEX

Distressed Investing Merger Arbitrage Equity Market Neutral

0.58 0.57 0.30 0.76 0.31 0.34 0.59 0.49 0.54

-0.06 0.00 0.03 -0.03 0.21 0.06 0.08 0.13 0.11

Equity Hedge Global Macro

Managed Futures/Trend Following

Relative Value

Convertible Arbitrage

Multi-Strategy

Correlation – The degree to which the returns of two asset classes move in the same direction relative to their average returns. A correlation coefficient of “+1” would indicate that the two asset classes always move together. A correlation coefficient of “-1” would indicate they always move in opposite directions. Combining assets that are not well correlated (i.e., that have low or negative correlation) can result in a smoother, less volatile return stream, making the portfolio more efficient.

certain times throughout the year, and may be capped at a maximum percentage referred to as redemption gates. Often, hedge fund managers require investors to maintain their investment in the fund for some minimum time period (called a “lockup period”), such as one year. Private investment partnerships may be open to a limited number of investors and require a large initial minimum investment (such as $1 million to $20 million). While private partnership structures originally were the norm, the term “hedge fund” now represents different types of funds employing nontraditional portfolio management techniques, regardless of the legal structure. Today, many of the bestknown hedge fund strategies are accessible via mutual funds. These liquid hedge fund strategies offer many benefits, including greatly expanded access compared with that of traditional private placement funds, which typically require clients to meet certain SEC-mandated

HISTORY

Hedge funds are not a new concept. Alfred Winslow Jones created the first long/short equity (hedge) fund in 1949. At the time, it was a rather innovative concept, and it opened the door to the investment vehicles that we consider modern hedge funds. Through this first hedge fund, Mr. Jones was able to create positive returns during both rising and falling equity markets and produce a smoother return profile for investors by decreasing the downside risk of the portfolio. The fund experienced strong annualized performance of nearly 22% from 1949 to 1968, compared with the S&P 500 Index return of approximately 12% over that same period. In 1966, the first long/short equity mutual fund, the Hubshman Fund, was launched. Over the decades, long/short equity investing has become a staple for many institutional pension and endowment fund portfolios, either incorporated as a dedicated strategy or as a sleeve of multi- strategy funds. Meanwhile, the number of other strategies employed in hedge funds has risen substantially (see STRATEGY DESCRIPTIONS section).

With assets of more than $2 trillion, hedge funds are not an asset class but a group of different manager strategies. Whether the hedge fund is structured as a limited partnership, mutual fund, or separate account, investors in hedge funds are relying on a manager’s investment skill set to execute a particular strategy. The level of risk varies greatly among hedge fund

strategies and may depend on the manager’s use of leverage and derivative instruments, among other factors. HEDGE FUND LEGAL STRUCTURES Investments in private partnership hedge funds are generally illiquid, with withdrawals that are allowed only at

COMPARISON OF DIFFERENT STRUCTURES

LIMITED PARTNERSHIP/PRIVATE PLACEMENT FUND

MUTUAL FUND

Access

Limited; investor must meet certain criteria (such as $5 million in investable assets) Typically high (such as $1 million) Typically one to two years Typically quarterly, but can vary  Virtually unlimited Typically opaque; at manager’s discretion Often employed, but not always; can be very high (such as 10x) Typically quarterly, but can vary Typically 2% Structured in a variety of ways (such as 20% of profits above a 5% hurdle)

 None

Minimum Investment Lockup Periods Investor Liquidity Strategies Available Holdings Transparency Leverage Valuation Frequency Management Fees Performance Fees

 Typically none  None  Daily Somewhat limited

 Moderately transparent  Constrained by the SEC; typically no more than 30% (1.3x)  Daily  Typically 1% to 2%  Typically none

Regulatory Oversight Tax Form

 Full

Limited

K-1; can be delayed

 1099

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eligibility criteria and also are accompanied by high minimum investments. Although some strategies with high leverage or illiquid holdings cannot be created within the restrictions of a daily valued mutual fund, the number of these strategies has dwindled over the years as modern hedge fund managers have found ways to recreate everything from managed futures to long/short debt within the constraints of a standard mutual fund. Based on our analysis of Morningstar hedge fund constituents, we estimate that mutual fund offerings of hedge fund strategies represented more than 250 distinct funds with over $175 billion in assets at the end of 2014. As many of these funds are new (with limited public track records and from small firms making their first foray into the mutual fund world), we strongly recommend that appropriate due diligence be performed before making an investment in these funds. STRATEGY DESCRIPTIONS It is important for an investor to understand the particular investment strategy employed by any given fund. Understanding the strategy can provide much-needed clues about expected returns, risk, and fit in a portfolio. Hedge fund strategies come in a variety of flavors, each with different objectives, limitations, and risk/return profiles. In the paragraphs that follow, we have identified the eight most common strategies and provided a general definition of each. Investors should note that there are few hedge funds with exactly the same investment strategy, as one of the greatest attractions of the hedge fund vehicle for managers is a higher level of investment autonomy. In addition, many hedge funds fall into multiple strategies or change investment strategies over time as opportunities arise. Long/Short Equity (including short-biased funds): This investment strategy involves purchasing securities that are expected to increase in value and selling short the securities a manager expects

to decline in value. Typically, long/short managers use variable market exposure to capture directional moves in the market. A common version of long/short (known as 130/30) uses the proceeds from the short investments as leverage to buy more than 100% of stocks long. Short-biased managers attempt to make money by expressing a bearish view on certain stocks and opportunistically shorting the names they find unattractive. Relative Value: These strategies typically involve finding small mispricings between similar investment vehicles. The strategy is often enacted with fixed-income instruments and generally relies on the use of mathematical models to identify fractional mispricings on derivative investments such as swaps, futures, options, or forward contracts. A hedge fund manager typically buys the cheaper derivative instrument, shorts the physical bond, and waits for the prices to converge. Relative value strategies generally involve a great deal of leverage, as the nominal returns are typically quite small and need the amplification of leverage in order to provide a meaningful return after transaction expenses. Arbitrage Strategies (merger arbitrage, convertible arbitrage and event-driven strategies): Pure arbitrage is typically defined as “low risk” because the hedge fund manager simultaneously purchases an asset at a lower price and sells the same or similar asset (elsewhere) at a higher price. Examples include buying a stock and selling the same stock trading on two different exchanges at slightly different prices or purchasing the target company in cash merger/acquisition offers for less than the acquisition price before the deal closes. Generally, these strategies are not exposed to the overall price movements of broad asset classes such as the stock or bond markets. These strategies may apply leverage in order to amplify the otherwise small returns expected from the transactions. Relative value strategies are often included in this category when or if there is little downside risk to their investment profile.

Distressed Investing: Often called vulture funds, these strategies involve buying the assets of a company in bankruptcy (or just prior to bankruptcy) in an effort to lay claim to some collateral or in an attempt to achieve better value for the assets post- bankruptcy. Another form of distressed investing involves giving a failing company a last lifeline of credit in exchange for a very high interest rate (and partial ownership in the company). Distressed investing often has a binary return pattern in which investors can make sizable returns or lose most of their investment if the deal fails. Diversification within the fund can mitigate the downside risk of individual transactions. Activist Investing: Unlike distressed- investment managers, activist managers often target healthy companies but aim to force them to change some policy or capital allocation in order to unlock hidden value. Examples include a hedge fund manager getting board seats in order to force a dividend payout or enough votes to install preferred executives. The goal of activist investors is to force the company in a direction that will unlock short-term stock gains, but these moves may not always be in the long-term interest of the firm. Therefore, activists act quickly and exert pressure on management via large ownership stakes. Global Macro/Tactical Trading: As the name implies, global macro hedge funds evaluate large macroeconomic trends and attempt to tacticall==y allocate to those trends when potential returns look favorable. Global macro hedge funds typically have an unconstrained mandate and are often called “go-anywhere” funds due to their ability to invest across asset classes and geographical boundaries. These managers often base their investment moves on quantitative tactical models and may use leverage or shorting to capitalize on very attractive valuations or poor valuations, respectively.

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deliver unfavorable results. At Commerce Trust, our research teams of highly trained analysts are behind the scenes performing hedge fund due diligence and working with your portfolio manager to identify the best hedge fund solutions for your portfolio. CONCLUSION We believe that a well-diversified, moderate allocation to hedge funds can enhance diversification and reduce volatility in a portfolio. A thoughtful allocation to hedge funds can act as portfolio ballast in times of stress in the equity markets. This feature is particularly useful in periods of low bond yields, when large allocations to fixed income are relatively unattractive and equity volatility remains the largest source of portfolio risk. However, each hedge fund strategy has its own risk profile, with risk factors including the uncertainty of strategy returns, possible style drift, execution risk, and potential changes in management or investment staff. Ongoing due diligence and broad diversification across managers and categories are essential for mitigating these risks. DISCLOSURES This overview is provided by Commerce Trust Company, a division of Commerce Bank, and is strictly for general informational purposes only. Investors should carefully consider the investment objectives, risks, charges and expenses of this fund. This and other important information is contained in the fund’s prospectus from your financial professional and should be read carefully before investing. Commerce Bank does not provide tax advice. Please contact your tax professional to review your particular situation before investing. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document. Past performance does not guarantee future results, and information provided is not to be construed as solicitation to buy or sell any particular security. Diversification does not guarantee a profit or protect against all risk.

HYPOTHETICAL RETURN/RISK OF A PORTFOLIO

WITH ALTERNATIVES

WITHOUT ALTERNATIVES

EXPECTED RISK (STANDARD DEVIATION)

ROLE IN A PORTFOLIO We believe the greatest benefit of employing hedge funds in a portfolio is potential risk reduction. The majority of volatility in most traditional portfolios is from the equity component, and hedge funds (and many other alternative investments) typically exhibit low correlations to stocks. This means they have a distinct return pattern and do not depend on the direction of equity (or bond markets). This independent return stream can potentially act as a buffer or add to a portfolio’s relative returns when markets decline. Hedge funds can also provide an alternative source of returns that is less sensitive to interest rate moves than either equity or fixed income. As a portfolio diversifier, hedge funds can smooth returns during volatile markets. When used as a complement to a balanced portfolio, hedge funds can improve the portfolio’s overall efficiency (lower risk for a given level of returns). THE IMPORTANCE OF DUE DILIGENCE As with all investments, hedge funds carry risk. The particular underlying hedge fund strategy may be poor, or the manager may not execute well an otherwise good strategy. From time to time, fraud in a hedge fund generates prominent headlines. Appropriate due diligence can uncover risks, helping investors to avoid hedge funds that may

Market Neutral: This investment strategy is often considered a subset of long/ short equity, as the most common form of market-neutral investing involves a strategy of investing 100% long and 100% short in order to hedge out all market moves but still capture the return spread between the long and short positions. There are multiple variations of this strategy that may involve relative value or arbitrage techniques to enhance returns or the use of index futures to hedge equity moves. The end goal is to create absolute returns while maintaining net zero exposure to the equity markets. These strategies are typically characterized by low risk and low return unless leverage is employed. Managed Futures: Managed futures strategies are a subset of the hedge fund universe and represent an alternative investment strategy in which professional managers use futures contracts instead of direct investments in stocks, bonds, commodities, or currencies. A managed futures strategy (either through a private fund, mutual fund structure, or separate securities) takes long and short positions in futures contracts and options on futures contracts while holding the investors’ underlying assets inmoney market accounts or short-term government securities. These managers typically use mathematical models to seek price trends (either positive or negative) in various futures contracts.

NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE Commerce Trust Company is a division of Commerce Bank.

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