ACTUARIAL INSIGHTS INTO HEDGE FUND MANAGEMENT R S

ACTUARIAL INSIGHTS INTO HEDGE FUND MANAGEMENT R S Clarkson

Ø Risk is downside in nature Ø Look beyond the recent past. Ø Watch out for departures from prudent behaviour. Ø There is nothing to fear but fear. Ø Equities, not bonds or cash, for the long run. Ø Beware of rising inflation. Ø The power of developing nations. Ø Investment of the fourth kind.

RISK IS DOWNSIDE IN NATURE ADAM SMITH The chance of loss is by most men undervalued. Ø BENJAMIN GRAHAM Security of capital. Ø WARREN BUFFETT Harm or injury to purchasing power. Ø FINANCE THEORY Variance or standard deviation of past return Ø OCTOBER 1992 Equities about to become much less risky? Ø

LOOK BEYOND THE RECENT PAST Ø OFF THE RADAR SCREEN Our data didn’t go back far enough Ø BLACK SWAN It was an event that had never happened before. Ø FIVE SIGMA EVENT No significant probability on our model

LOOK BEYOND THE RECENT PAST LONG-TERM CAPITAL MANAGEMENT 1998 Models did not go back to 1992 or 1987 Ø NORTHERN ROCK FSA COMMENT 2007 We had it as a low probability of getting into difficulty Ø ALLIANCE & LEICESTER COMMENT 2007 Our strategic review in 1999 underestimated correlations Ø ROYAL BANK OF SCOTLAND CHAIRMAN 2008 1 in 10, 000 chances do turn up Ø UBS COMMENT 2008 Crucial risk model based on favourable 5 year period with low volatility Ø

WHICH BANK? WHICH YEAR? Few directors had any real banking experience. Ø Committed the cardinal banking sin of lending long-term against short-term borrowing in the commercial money market. Ø Deputation to Bank of England to ask for loan. Ø CONTEMPORARY COMMENT Universal loss of credit, endless suspicions Ø Need to check previous exorbitant level of available credit Ø

LOOK BEYOND THE RECENT PAST WINSTON CHURCHILL The further you look back in history, the further you can look forward. Ø ADAM SMITH Restrictions on liberty of bankers necessary. Ø INSTITUTE OF ACTUARIES Certum ex incertis – certainty out of uncertainties Ø FACULTY OF ACTUARIES Ad finem fidelis – Faithful to the end Ø

DEPARTURES FROM PRUDENT BEHAVIOUR Large private equity deals on low interest rates Ø Covenant-lite corporate borrowing Ø Wall Street driving demand for sub-prime loans Ø No reasonable margin on sub-prime loans Ø Mortgages of 5 times joint salaries Ø 125% loan-to-value ratios Ø £ 7. 5 m maximum mortgage – now £ 550, 000 Ø

THERE IS NOTHING TO FEAR BUT FEAR ADAM SMITH – HISTORY OF ASTRONOMY Panic terrors always excited by the sudden onset of unexpected danger. Ø ALAN GREENSPAN – THE AGE OF TURBULENCE Normal rational behaviour impossible when fear exists. Even investment bankers can be paralysed by fear. Ø US BANK TREASURER – SEPTEMBER 2007 People are terrified of reputational damage. They know it could be a career-ending move. Ø US BANKER – SEPTEMBER 2007 Lending to anything east of a 212 local telephone code could be a terminal experience. Ø

EQUITIES, NOT BONDS OR CASH, FOR THE LONG RUN RISK ELEMENT Proportionate shortfall in real terms over given period OR Square of proportionate shortfall Ø RISK VALUE Average risk element over 100 year history Ø UK EQUITIES AND LONG GILTS Equities less risky over 4 years or longer Ø EQUITY RISK PREMIUM PUZZLE? Myopic loss aversion, corrected by actuarial approach Ø

INVESTMENT OF THE THIRD KIND NEW MONEY SEPTEMBER 2000 Ø Billiton also rights issue Ø Rio Tinto Lloyds TSB Ø Standard Chartered Ø Ø ICI also rights issue Ø Rentokil Initial FTSE All-Share Index September 2000 new money 40% fall to December 2002 4% fall to December 2002

BEWARE OF RISING INFLATION 12 TH MARCH 2008 30 TH MAY 2008 FINANCIAL TIMES Ø INSIGHT ARTICLE Inflation cat jumps out of the bag to stalk credit markets. There is little useful history to predict what might happen to the corporate bond market if inflation really does take hold. Ø MARKETS Bond yields hit high as inflation fears mount.

THE POWER OF DEVELOPING NATIONS Ø Very rapid economic growth Ø Less restrictive legislation Ø BUT danger of high inflation Ø BUT poorer corporate governance Ø Sovereign wealth funds Ø Strategic stakes in key industries

INVESTMENT OF THE THIRD KIND RISK SCREEN Inadmissible if significant fall in earnings Ø MEDIUM TERM VALUE SCREEN Rank by utility function U = G – c. R Ø G 12 months consensus earnings growth Ø R prospective price-earnings ratio Ø C positive constant to disadvantage high R Ø PORTFOLIO GUIDELINES 4% in top 10 3. 5% in next 10 2. 5% in next 10 Annual rebalancing Ø PERFORMANCE TREND Around 5% p. a. out performance of FTSE All-Share Index Ø

DECEMBER 2005 ASSESSMENTS FTSE 100 COMPANIES Rank Company February 2006 1 BHP Billiton ! 111 5 Man Group ! 109 6 Persimmon ? 107 7 Northern Rock ? ? 114 FTSE All-Share Index 103 May 2008 206 194 39 ? 109

DECEMBER 2005 ASSESSMENTS FTSE 250 COMPANIES Rank 1 2 3 4 5 6 7 8 9 10 Company Venture Production ! Vedanta Resources ! *Burren Energy ! Lonmin ! Tullow Oil ! Informa William Hill Kensington Group ? ? Amlin Logica CMG FTSE All-Share Index February 2006 123 115 109 129 117 102 110 108 96 102 103 * Reinvested in ENRC December 2007 May 2008 157 291 310 209 341 87 70 ? 116 70 109

INVESTMENT OF THE FOURTH KIND RISK SCREEN Inadmissible if significant fall in earnings Ø MEDIUM TERM VALUE SCREEN Require high value of U = G – c. R Ø LONG TERM VALUE SCREEN Rank by 4 -component long-term growth rate (LTGR) Ø PORTFOLIO GUIDELINES Highly unconventional – similar to Warren Buffett Ø PERFORMANCE TREND Around 10% p. a. out performance of FTSE All-Share Index ? Ø

PORTFOLIO GUIDELINES Maximum investment 5% of current portfolio value Ignore sector weightings Ø Do not sell unless overvalued in terms of U or LTGR deteriorates. Ø Do not rebalance. Ø Switch if much more attractive opportunity available Ø Eg: XSTRATA Cost 2. 5% of May 2008 portfolio value Valuation 18% of May 2008 portfolio value Ø

LONG TERM GROWTH RATE Ø Volume growth Ø Size and stability of profit margins Ø Ability to finance growth Ø Operational flexibility in economic downturn Ø Assess each component on scale of 1 to 7

MAN GROUP VOLUME GROWTH Ø Fast becoming the Mc. Donald’s of alternative assets Ø Excellent performance of AHL Diversified fund Ø BUT poor Global Strategies performance Ø Targeting individuals and institutions enriched by commodities boom Ø Good global retail network Ø Still expanding unlike many competitors

MAN GROUP SIZE AND STABILITY OF PROFIT MARGINS AHL costs investors 4% p. a. and 20% performance fee Ø Elsewhere around 2% p. a. and 20% Ø No serious threat to high industry margins Ø ABILITY TO FINANCE GROWTH Ø Low expansion costs because of franchise nature Ø $1. 5 bn cash to buy smaller rivals and hire talent Ø OPERATIONAL FLEXIBILITY IN ECONOMIC DOWNTURN Ø AHL thrived in recent turbulence Ø Demand for alternative assets increases in difficult times Ø More opportunities from tighter bank regulation Ø

2007 HEDGE FUND PERFORMANCE CS TREMONT DATA SECTOR ALL HEDGE FUNDS Multi-Strategy Equity Market Neutral Risk Arbitrage Distressed Dedicated Short Bias Managed Futures Convertible Arbitrage Fixed Income Arbitrage % 12 12 9 9 8 6 6 5 4 FTSE All-Share Index 2

2007 HEDGE FUND PERFORMANCE CS TREMONT DATA SECTOR Emerging Markets Global Macro Event Driver Multi-strategy Long/Short Equity Event Driven ALL HEDGE FUNDS FTSE All-Share Index % 20 17 17 14 13 12 2