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.

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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.

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