July 17, 2017

James W. Sweetman, Senior Global Alternative Investment Strategist

Understanding the Data around Beta

• Beta is an important measure of a portfolio’s volatility. Historically, diversification using certain alternative investment strategies has proven effective at enhancing the risk/return profile of traditional portfolios by reducing beta.
• We recommend that investors reset expectations on the role alternative investments can play within their portfolios and structure a portfolio that best meets their investment objectives.

What it may mean for investors

• After years of strong returns, we believe that markets are likely to return to a fundamental stock picking market and volatility may rise. We believe that this is an appropriate time for investors to consider asset classes that can help manage beta (volatility) in their portfolios.

What is Beta?

In its easiest parlance, “beta” is a measure of an investment’s volatility or risk in relation to a specific benchmark. By definition, the benchmark has a beta of 1.0, and investments are measured according to how much they deviate from the benchmark. For example, using the MSCI World Index as the benchmark, an investment that exhibits more volatility than the MSCI World Index over time has a beta above 1.0. Yet, an investment with lower volatility will have a beta that is less than 1.0. Typically, higher-beta investments are riskier but may provide the potential for higher returns relative to the comparative benchmark; while lower-beta investments pose less risk but also typically provide lower returns relative to the benchmark.

• For example, using an extreme hypothetical case in which the benchmark returned +25 percent over time, an investment with a beta of 3.0 would return +75 percent. Similarly, when the benchmark declines -25 percent, the investment would decline -75 percent. (Importantly, this extreme example assumes that an investment has a perfect 1.0 correlation to the benchmark and has provided no sources of return besides the benchmark’s return.)

Using the above example, while a return of +75 percent could be considered an excellent long-term result to the upside, a loss of -75 percent could be devastating. In fact, following such a loss, an investment would have to return +300 percent just to break even.

Alternative Investments as a Potential Beta-Mitigator

In this report, when we refer to “alternative investments,” we mean hedge fund strategies including the relative value, macro, event-driven and equity-hedge strategies.

Traditional stock and bond portfolios (often referred to as “long-only” strategies) are generally heavily influenced by beta or broad market returns. They often perform in line with their benchmarks, particularly when they emphasize passive benchmarking strategies, such as an S&P 500 Index fund. Historically, many alternative investments have proven effective at enhancing traditional portfolios by reducing beta (or the adherence to benchmark returns) and by focusing on generating “alpha” (or excess return relative to the return of a benchmark). As the table below indicates, since hedge funds first began to be tracked by Hedge Fund Research (HFR) in 1990, they have produced higher absolute and risk-adjusted returns over time and lower maximum drawdowns than equity-market investments have—while exhibiting moderate-to-low beta measurements relative to equity and fixed income markets.

Table 1. Hedge Funds Historically Have Outperformed Equities with Lower Beta For the Period of January 1990 through June 2017Sources: Hedge Fund Research (HFR) and Bloomberg, 7/12/17. Total annualized returns: 1/1/90- 6/30/17. Relative Value = HFRI Relative Value Arbitrage (Total) Index, Macro = HFRI Macro (Total) Index, Event Driven = HFRI Event Driven (Total) Index, Equity Hedge = HFRI Equity Hedge (Total) Index, Govt./Credit Bonds = Bloomberg Barclays U.S. Government/Credit Bond Index. Table also shows S&P 500 Index and MSCI World Index. Standard Deviation is the measure of the variability of return earned by a portfolio. Generally, the larger the dispersion is, the greater the risk taken to achieve the return. Maximum Drawdown is the largest peak-to-trough decline during a specific record period of an investment or fund. It is usually quoted as the percentage between the peak and the trough. Sharpe Ratio is the annualized excess return of a particular investment or index over a guaranteed return (typically, the 90-day Treasury bill), divided by the annual standard deviation of the excess return. The higher the Sharpe ratio is, the better a fund’s returns have been relative to the amount of investment risk it has taken. Please see important information about index comparisons, strategy and index definitions, and asset class risk considerations at the end of this report. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

By their nature, alternative investments such as hedge funds are unique and atypical; thus, they do not fit neatly in a strategy or style box. Often, strategies that may appear to be similar on the surface actually can be quite different from one another upon deeper analysis. For alternative investments, beta can come from any combination of factors, including geography, market capitalization, style, sector, and credit quality, to name a few. The goal for investors is to identify the beta source they are looking to diversify and pick the alternative-investment strategy that can best complement their investment objective. An investment professional can assist in that effort.

Utilizing the S&P 500 Index as a benchmark, the average equity hedge fund manager generated 44 percent of its return from beta or market directionality and 56 percent from other sources of returns for the period from January 1990 through June 2017. During this same period, the correlation of the equity hedge strategy to the S&P 500 Index was 0.73, largely due to net long market exposures.¹

Analyzing beta and correlation together shows that the equity hedge strategy historically has moved in the same direction as the equity markets but has not fluctuated (up or down) as much. In other words, this strategy historically has participated in upward equity movements, while also limiting downside movements. Historically, the driver of strong risk-adjusted returns has been effective combination of beta and alpha. However, because alpha is unpredictable and not tied to a benchmark like beta, the anchor of returns has been lower beta relative to the equity markets.

The relative value hedge fund strategy is predicated on the realization of a valuation discrepancy between multiple fixed-income instruments. Historically, utilizing the Bloomberg Barclays U.S. Government/Credit Bond Index as the benchmark, the relative value strategy generated only 9 percent of its return from beta and 91 percent from other sources of return. Different from the equity hedge strategy, the relative value strategy had a low 0.09 correlation for the period from January 1990 through June 2017—as the low beta associated with the relative value strategy is not driven by classic market trends, but rather, by market discrepancies, and by the neutralization of certain fixed-income factors such as interest-rate rate and duration risk. We believe these characteristics make the relative value strategy a complementary investment to a traditional fixed-income portfolio, especially in a rising interest-rate environment—as it historically has generated 1.3 times the upside with similar volatility.

Resetting Investor Expectations for the Role of Alternative Investments

The multi-year market rally that started after the global financial crisis has had an extensive impact on investors around the world. Unprecedented global monetary policy, fueling unusually low market volatility and decreased dispersion (variability) of asset-class returns has limited opportunities to generate alpha. Beta mitigation (lowering beta) may not be appealing to an investor in a market environment in which returns from broad equity-market movements have outpaced the returns of many diversified portfolios. Yet, after years of strong equity-market returns, we have entered a period that we believe will result in a notable increase in return dispersion (or differences in asset performance) and eventually higher volatility as markets return to fundamental stock picking market driven by fundamentals and market participants focus on fundamentally-driven investing.

Historically, alternative investments have done a good job of complementing traditional portfolios, partly due to lower beta exposures. This historically has resulted in higher returns and lower overall risk for alternative investments over the long term. As such, we believe that now may well be the time to reset the role of alternative investments in qualified investors’ portfolios as a beta-mitigator—and investor views of their merits within a diversified asset-allocation framework.

Equities

Sean Lynch, CFA, Co-Head of Global Equity Strategy

Developed Markets: Our Favorite for New Equity Dollars

We continue to hold an evenweight recommendation on all equity asset groups, except for our underweight position in small caps. Yet, we also have a preference for where incremental equity investment dollars should be allocated. For those assets, we recommend that investors first target international developed markets (DM), then emerging markets (EM) and finally the U.S., where we prefer investment in large-cap stocks over mid caps and small caps. The rationale for favoring international equities has strengthened since the beginning of this year. Stronger earnings, more reasonable valuation, and a renewed focus on shareholders are the main reasons for our preference.

We use the MSCI EAFE Index as our DM equity benchmark. This index is heavily influenced by the Eurozone, Japan, and the United Kingdom. In the first quarter, earnings expectations rose in Europe for the first time in nearly six years. As Europe gets set to report second-quarter earnings, the expectation is that upbeat guidance will continue. For the MSCI EAFE Index overall, we expect second-quarter earnings growth to be in the low double digits, versus high-single-digit earnings growth in the U.S.

We expect the banking sector will be another key influence on healthy DM profit growth. Financials are the largest sector in the MSCI EAFE Index, and this sector’s performance should improve with better bank earnings growth. The Industrial and Consumer Discretionary sectors round out the top three. All of these areas should be in a good position as the Eurozone economy gradually improves. Current DM equity valuation also is reasonable, with a price/earnings multiple of 16.4 times our 2017 earnings estimates.

Finally, dividend yields are currently higher on the MSCI EAFE Index than on the S&P 500 Index, and we also may see companies begin to buy back stock, which could support earnings.

Our biggest concern for DM equities is central-bank tightening, particularly on the part of the European Central Bank and Bank of Japan. The prospect that the Eurozone could experience a “taper tantrum,” similar to the U.S. experience when the Federal Reserve first talked of initiating monetary tightening in 2013, cannot be ignored. We believe that Eurozone and Japanese central banks will be patient before materially tightening.

Key Takeaways

• Our preference for international equities has strengthened based on stronger earnings, more reasonable valuation, and a renewed shareholder focus (reflected in higher dividend yields than for U.S. companies and on the potential for stock buybacks). In fact, we expect second-quarter DM corporate earnings to increase at a low double-digit rate while U.S. earnings growth should be in the high single digits.
• Our biggest concern is the prospect for monetary tightening by DM central banks.

Fixed Income

Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

Europe’s Influence on the U.S. Fixed-Income Market

If longer-term U.S. rates are to move higher, we believe that the global fixed-income market will need to lead the way. For many years, the U.S. has offered some of the most attractive bond yields among high-quality countries. Over the past 12 months, the yield differential between 10-year Treasury securities and 10-year German bunds has averaged 1.9 percent. Currently, 10-year sovereign debt in the U.S currently offers investors 1.75 percent in additional yield over the German counterpart. Over the past few weeks, the 10-year Treasury note yield has increased by about 0.25 percent, a move that had little to do with events in the U.S. and everything to do with a rise in global rates as investors prepare for European Central Bank (ECB) tapering in the months ahead.

We look for the ECB to taper new bond purchases at a very gradual pace beginning next year. While longer-term rates may move modestly higher as a result, we do not anticipate conditions that would warrant a spike in global yields. This should help keep longer-term U.S. rates relatively contained, despite the prospects of Federal Reserve balance-sheet reduction and further fed funds rate increases here in the U.S.

Key Takeaways

• It is difficult for developed-market sovereign-bond rates to diverge further given the influence of global yield demand.
• Central banks control short-term rates, but they do not explicitly control longer-term rates. We look for short-term U.S. rates to rise at a faster pace than long-term rates over the next year as the Treasury yield curve continues to flatten.

Ten-Year U.S. Treasury Note and German Sovereign Bond YieldsSource: Bloomberg; 7/13/17. Yields represent past performance. Past performance is no guarantee of future results. The current yield may be lower or higher than that quoted. Yields fluctuate as market conditions change.

Real Assets

John LaForge, Head of Real Asset Strategy

REITs—Still Overweight, But We Have Concerns

“Be kind; every man you meet is fighting a hard battle.”--Ian Maclaren

WFII is tactically (6-18 months) overweight Real Estate Investment Trusts (REITs) in 2017. At certain points during the year, this trade has looked good; at other points, not so good. In recent weeks, the overweight position has fallen back into the “not so good” camp. This makes sense to us—as long-term rates have been rising. For example, the 10-year Treasury yield has risen in recent weeks from 2.13 percent to a high of 2.39 percent. This 26-basis-point move may not sound like much, but in percentage terms, it is 12 percent. As an interest-rate-sensitive sector, REITs were bound to get hit by this.

We’re not panicked, but we have become a bit uneasy. Fundamentals still appear relatively good, but the technicals have moved to concerning points. Technicals are an important perspective, because they tell us how an asset class “is performing” against our fundamental views on how the asset “should be performing.” The chart below shows two different REIT perspectives—which we are watching closely. The top panel highlights a main U.S. REIT index. The bottom panel shows how the same U.S. REIT index is performing versus other major assets in a hypothetical model portfolio. The technical support levels that we are most concerned about are drawn in red. Should both of these levels be broken, we likely will remove our overweight positioning.

Key Takeaways

• REITs have weakened as long-term interest rates have risen.
• We are still overweight REITs, but we outline technical levels (below) that would change our recommendation.

Domestic REITs versus a Hypothetical Model PortfolioSources: Bloomberg, Wells Fargo Investment Institute. Daily Data: 1/2/2014 – 7/12/2017. Ratio is the FTSE NAREIT All Equity REITs Index Total Return divided by the hypothetical model portfolio. Model portfolio is constructed using static weights of the following indices: S&P 500 Index Total Return (18%), Russell Midcap Index Total Return (7%), FTSE NAREIT Developed REITs Index Total Return (3%), Russell 2000 Index Total Return (5%), Dow Jones Private Equity Index Total Return (6%), Moody’s RCA CPPI Composite National Index (5%), Bloomberg Barclays U.S. Agg 5-7 Year Bond Index Total Return (12%), Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index Total Return (5%), Bloomberg Barclays U.S. Treasury Bills Index Total Return (3%), Bloomberg Barclays U.S. Corporate High Yield Index Total Return (6%), JPMorgan EMBI Global Total Return (6%), JPMorgan GBI Global ex-U.S. (2%), HFRI Relative Value (Total) Index (3%), HFRI Macro (Total) Index (3%), HFRI Equity Hedge (Total) Index (2%), HFRI Event-Driven (Total) Index (2%), MSCI Emerging Markets Index Total Return (4%), MSCI EAFE Developed Market Index Total Return (6%), Bloomberg Commodity Index Total Return (2%). Please see important information about index comparisons, strategy and index definitions and asset class risk considerations at the end of this report. An index is unmanaged and not available for direct investment. Hypothetical and past performance is no guarantee of future results.

Alternative Investments

Justin Lenarcic, Global Alternative Investment Strategist

Using Beta to Make Investment Decisions

Building a diversified portfolio using hedge funds sometimes can be challenging. Yet developing expectations of how strategies interact with other asset classes is critical to investment selection and sizing. There are multiple statistical methods for quantifying that “interaction,” with beta being one of the more common (along with correlation). As Jim Sweetman discussed earlier in this report, beta measures how sensitive (or volatile) a portfolio, strategy or fund is relative to a benchmark, while correlation measures the degree to which they move in relation to one another.

Throughout a full market cycle, qualified investors may have vastly different investment objectives for their hedge fund portfolio. But with an eight-year-old U.S. equity bull market, combined with the prospect of higher interest rates and wider credit spreads, a more common reason for allocating to hedge funds seems to be diversifying equity, fixed income, or credit risk.

As discussed in the cover story, understanding the meaning and application of beta can help make addressing this objective more intuitive. For example, if an investor’s portfolio has a significant amount of equity-market exposure, perhaps through passively managed mutual funds or exchange-traded funds, then adding a strategy like Event Driven—Activist, a strategy that has a historical beta of 0.67 to global equities, would not be expected to significantly mitigate equity market risk. However, a strategy such as Relative Value—Asset Backed might make sense, especially considering its low beta to global fixed income, equities, and credit.

Key Takeaways

• Analyzing beta can be a valuable tool when allocating to hedge fund strategies.
• Not all hedge fund strategies have the same beta characteristics. Consider these differences when building a diversified portfolio.

Reducing Beta is a Core Objective of Most Hedge Fund StrategiesSources: Hedge Fund Research, Inc.; MPI Stylus, Wells Fargo Investment Institute (WFII), May 2017. Beta to global fixed income is calculated against the Bank of America/Merrill Lynch Global Government Bond Index. Beta to global equities is calculated against the MSCI All Country Word Index. Beta to global credit is calculated against the Bank of America/Merrill Lynch Global Corporate Bond Index. Beta is calculated using monthly returns from the inception date of the representative index through May 2017, and then, it is annualized. Please see important information about index/strategy comparisons, strategy definitions and asset class risk considerations at the end of this report. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

¹ Correlation measures the degree to which asset classes move in sync; it does not measure the magnitude of that movement.

Important Information about Index/Strategy Comparisons

Index and strategy return information is provided for illustrative purposes only. Index/strategy returns represent general market results and do not reflect actual portfolio returns, the experience of any investor, or the impact of any fees, expenses or taxes applicable to an actual investment. Nor do such returns constitute a recommendation to invest in any particular fund or strategy. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. Because the HFR indices are calculated based on information that is voluntarily provided actual returns may be higher or lower than those reported. Unlike most asset class indices, HFR Index returns reflect deduction for fees and expenses. Comparisons to benchmarks have limitations because benchmarks have volatility and other material characteristics that may differ from those of an investor's portfolio. Because of these differences, benchmarks should not be relied upon as an accurate measure of comparison. There is no guarantee that any of the securities in an investor's portfolio are included in the representative benchmarks. An index is unmanaged and not available for direct investment. Hypothetical results do not represent actual trading. Hypothetical and past performance does not guarantee future results. Please see below for the risks associated with the representative asset classes and the definitions of the indices and strategies.

Risk Factors

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. There is no guarantee that dividend-paying stocks will return more than the overall stock market. Dividends are not guaranteed and are subject to change or elimination. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Definitions

Bank of America/Merrill Lynch Global Government Bond Index tracks the performance of public debt of investment-grade sovereign issuers, issued and denominated in their own domestic market and currency.

Bank of America/Merrill Lynch Global Corporate Bond Index tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or eurobond markets.

The Bloomberg Barclays US Government/Credit Bond Index is composed of U.S. Government and high quality investment grade corporate fixed income securities with maturities greater than one year. The Barclays Capital U.S. Government/Credit Bond Index is copyrighted by Barclays Bank, plc.

Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.

Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.

Bloomberg Barclays U.S. Treasury Bills Index is representative of money markets

Bloomberg Barclays U.S. Corporate High Yield Index is a broad-based index that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS ABS, and CMBS.

Bloomberg Commodity Index is calculated on an excess return basis and reflects commodity futures price movements.

Dow Jones Private Equity Index tracks the performance of globally listed private equity stocks and is composed of the 25 largest and most liquid stocks of private equity companies listed on the world’s stock exchanges. Dow Jones Indexes is responsible for the selection of the index components, the index calculation, the ongoing maintenance and the index dissemination. To ensure that the Private Equity Index is always accurate and is calculated with the most up-todate constituent data, the component data (i.e. number of shares, free float factor, weighting factor) of the Private Equity Index is reviewed on a quarterly basis. The resulting changes to the index are implemented after the closing on the third Friday in March, June, September, and December and are effective the next trading day.

FTSE NAREIT All Equity REITs Index, a subset of the All REITs Index, is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria.

FTSE NAREIT Developed REITs Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide.

Emerging Market Fixed Income (U.S. Dollar) J.P. Morgan Emerging Markets Bond Index (EMBI Global) currently covers 27 emerging market countries. Included in the EMBI Global are U.S. dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issues by sovereign and quasi-sovereign entities.

Developed Market Ex-U.S. Fixed Income (Hedged) J.P. Morgan Non-U.S Global GBI Hedged Index is an unmanaged index market representative of the total return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.

MSCI EAFE Developed Market Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The Index consists of the following 21 developed market country indexes. Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

MSCI World Index US$ is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

Moody’s/RCA CPPI Composite National Index measures property price at a national level. It is based on repeat-sales transactions that occurred at any time up through the month prior to the current report. Because CPPI allows for backward revisions and incorporates any new data we receive subsequent to publishing, full history (from inception to current month) of future indices will reflect adjustments due to additional transaction data.

Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represents approximately 25 percent of the total market capitalization of the Russell 1000 Index.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately eight percent of the total market capitalization of the Russell 3000 Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market.

S&P 500 Index w/ Dividends is a value weighted index that covers 500 industrial, utility, transportation and financial companies in the U.S. markets.

HFRI Strategy Definitions

The HFRI Relative Value Arbitrage (Total) Index tracks funds that attempt to take advantage of relative pricing discrepancies between instruments including equities, debt, options and futures. Managers may use mathematical, fundamental, or technical analysis to determine misvaluations. Securities may be mispriced relative to the underlying security, related securities, groups of securities, or the overall market. Many funds use leverage and seek opportunities globally. Arbitrage strategies include dividend arbitrage, pairs trading, options arbitrage and yield curve trading.

The HFRI Relative Value: Fixed Income – Sovereign Index includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a sovereign fixed income instrument. Strategies employ an investment process designed to isolate attractive opportunities between a variety of fixed income instruments, typically realizing an attractive spread between multiple sovereign bonds or between a corporate and risk free government bond. Fixed Income Sovereign typically employ multiple investment processes including both quantitative and fundamental discretionary approaches and relative to other Relative Value Arbitrage sub-strategies, these have the most significant top-down macro influences, relative to the more idiosyncratic fundamental approaches employed. RV: Fixed Income: Sovereign funds would typically have a minimum of 50% exposure to global sovereign fixed income markets, but characteristically maintain lower net exposure than similar strategies in Macro: Multi-Strategy sub-strategy.

The HFRI Relative Value: Fixed Income – Corporate Index includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a corporate fixed income instrument.

Strategies employ an investment process designed to isolate attractive opportunities between a variety of fixed income instruments, typically realizing an attractive spread between multiple corporate bonds or between a corporate and risk free government bond. Fixed Income: Corporate strategies differ from Event Driven: Credit Arbitrage in that the former more typically involve more general market hedges which may vary in the degree to which they limit fixed income market exposure, while the later typically involve arbitrage positions with little or no net credit market exposure, but are predicated on specific, anticipated idiosyncratic developments.

The HFRI Relative Value: Fixed Income – Asset Backed Index includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a fixed income instrument backed physical collateral or other financial obligations (loans, credit cards) other than those of a specific corporation. Strategies employ an investment process designed to isolate attractive opportunities between a variety of fixed income instruments specifically securitized by collateral commitments which frequently include loans, pools and portfolios of loans, receivables, real estate, machinery or other tangible financial commitments. Investment thesis may be predicated on an attractive spread given the nature and quality of the collateral, the liquidity characteristics of the underlying instruments and on issuance and trends in collateralized fixed income instruments, broadly speaking. In many cases, investment managers hedge, limit or offset interest rate exposure in the interest of isolating the risk of the position to strictly the yield disparity of the instrument relative to the lower risk instruments.

The HFRI Macro (Total) Index tracks managers that trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods.

HFRI Macro: Discretionary Thematic Index: Thematic strategies are primarily reliant on the evaluation of market data, relationships and influences, as interpreted by an individual or group of individuals who make decisions on portfolio positions; strategies employ an investment process most heavily influenced by top down analysis of macroeconomic variables. Investment Managers may trade actively in developed and emerging markets, focusing on both absolute and relative levels on equity markets, interest rates/fixed income markets, currency and commodity markets; frequently employing spread trades to isolate a differential between instrument identified by the Investment Manager to be inconsistent with expected value. Portfolio positions typically are predicated on the evolution of investment themes the Manager expect to materialize over a relevant time frame, which in many cases contain contrarian or volatility focused components.

HFRI Macro: Systematic Diversified Index: Systematic Diversified strategies have investment processes typically as function of mathematical, algorithmic and technical models, with little or no influence of individuals over the portfolio positioning. Strategies which employ an investment process designed to identify opportunities in markets exhibiting trending or momentum characteristics across individual instruments or asset classes. Strategies typically employ quantitative process which focus on statistically robust or technical patterns in the return series of the asset, and typically focus on highly liquid instruments and maintain shorter holding periods than either discretionary or mean reverting strategies. Although some strategies seek to employ counter trend models, strategies benefit most from an environment characterized by persistent, discernable trending behavior. Systematic: Diversified strategies typically would expect to have no greater than 35% of portfolio in either dedicated currency or commodity exposures over a given market cycle.

HFRI Event Driven (Total) Index is also known as "corporate life cycle" investing. This involves investing in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks. The portfolio of some Event-Driven managers may shift in majority weighting between Risk Arbitrage and Distressed Securities, while others may take a broader scope. Instruments include long and short common and preferred stocks, as well as debt securities and options. Leverage may be used by some managers. Fund managers may hedge against market risk by purchasing S&P put options or put option spreads.

HFRI Event Driven: Activist Index: Activist strategies may obtain or attempt to obtain representation of the company's board of directors in an effort to impact the firm's policies or strategic direction and in some cases may advocate activities such as division or asset sales, partial or complete corporate divestiture, dividend or share buybacks, and changes in management. Strategies employ an investment process primarily focused on opportunities in equity and equity related instruments of companies which are currently or prospectively engaged in a corporate transaction, security issuance/repurchase, asset sales, division spin-off or other catalyst oriented situation. These involve both announced transactions as well as situations which pre-, post-date or situations in which no formal announcement is expected to occur. Activist strategies are distinguished from other Event Driven strategies in that, over a given market cycle, Activist strategies would expect to have greater than 50% of the portfolio in activist positions, as described.

HFRI Event Driven: Distressed/Restructuring Index: Distressed/Restructuring strategies which employ an investment process focused on corporate fixed income instruments, primarily on corporate credit instruments of companies trading at significant discounts to their value at issuance or obliged (par value) at maturity as a result of either formal bankruptcy proceeding or financial market perception of near term proceedings. Managers are typically actively involved with the management of these companies, frequently involved on creditors' committees in negotiating the exchange of securities for alternative obligations, either swaps of debt, equity or hybrid securities. Managers employ fundamental credit processes focused on valuation and asset coverage of securities of distressed firms; in most cases portfolio exposures are concentrated in instruments which are publicly traded, in some cases actively and in others under reduced liquidity but in general for which a reasonable public market exists. In contrast to Special Situations, Distressed Strategies employ primarily debt (greater than 60%) but also may maintain related equity exposure.

HFRI Event Driven: Merger Arbitrage Index: Merger Arbitrage strategies which employ an investment process primarily focused on opportunities in equity and equity related instruments of companies which are currently engaged in a corporate transaction. Merger Arbitrage involves primarily announced transactions, typically with limited or no exposure to situations which pre-, post-date or situations in which no formal announcement is expected to occur. Opportunities are frequently presented in cross border, collared and international transactions which incorporate multiple geographic regulatory institutions, with typically involve minimal exposure to corporate credits. Merger arbitrage strategies typically have over 75% of positions in announced transactions over a given market cycle.

The HFRI Equity Hedge (Total) Index consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 index and put spreads. Conservative funds mitigate market risk by maintaining market exposure from zero to 100 percent. Aggressive funds may magnify market risk by exceeding 100 percent exposure and, in some instances, maintain a short exposure. In addition to equities, some funds may have limited assets invested in other types of securities.

The HFRI Equity Hedge: Multi-Strategy Index: Equity Hedge: Multi-Strategy Investment Managers maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH Multi-Strategy managers typically do not maintain more than 50% exposure in any one Equity Hedge sub-strategy.

HFRI Equity Hedge: Equity Market Neutral Index: Equity Market Neutral strategies employ sophisticated quantitative techniques of analyzing price data to ascertain information about future price movement and relationships between securities, select securities for purchase and sale. These can include both Factor-based and Statistical Arbitrage/Trading strategies. Factor-based investment strategies include strategies in which the investment thesis is predicated on the systematic analysis of common relationships between securities. In many but not all cases, portfolios are constructed to be neutral to one or multiple variables, such as broader equity markets in dollar or beta terms, and leverage is frequently employed to enhance the return profile of the positions identified. Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high frequency techniques may be employed and trading strategies may also be employed on the basis on technical analysis or opportunistically to exploit new information the investment manager believes has not been fully, completely or accurately discounted into current security prices. Equity Market Neutral Strategies typically maintain characteristic net equity market exposure no greater than 10% long or short.

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