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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.WileyFinance.com. ffirs.qxd 12/28/05 10:46 AM Page ii

VINH Q. TRAN John Wiley & Sons, Inc. Evaluating Hedge Fund Performance ffirs.qxd 12/28/05 10:46 AM Page iii

www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Tran, Vinh Quang, 1946- Evaluating hedge fund performance / Vinh Q. Tran. p. cm.—(Wiley finance series) ISBN-13 978-0-471-68171-7 (cloth) ISBN-10 0-471-68171-7 (cloth) 1. Hedge funds—United States. I. Title. II. Series. HG4930.T73 2006 332.64’5—dc22 2005026226 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 ffirs.qxd 12/28/05 10:46 AM Page iv

In loving memory of my beloved mother ffirs.qxd 12/28/05 10:46 AM Page v

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Contents Foreword by Thomas Schneeweis xi Acknowledgments xiii Introduction by David Brown xv PART ONE A Primer on Hedge Funds 1 CHAPTER 1 The Market Goes Up Forever. The Paradox of Long-Term Investing 3 Flaws of Long-Term Investing 3 Wealth-Reducing Effects of Volatility 7 Diversification to Reduce Risks 16 Long-Term Investing with Low-Correlation Assets and Downside Protection 20 CHAPTER 2 It’s the Risk, Not the Return: Using Hedge Funds to Reduce Portfolio Risks 23 Not Necessarily Higher Returns 24 Consistency of Returns 28 Low Correlation with the Stock Market 31 Portfolio Effects of Hedge Funds 32 Alternative Investments in Uncertain Markets 38 Wealth Preservation 40 Prospective Long-Term Returns and Risks of Stocks 42 vii ftoc.qxd 12/28/05 10:48 AM Page vii

CHAPTER 3 Going for the Gold: Growth and Strategies of Hedge Funds 45 Size of the Hedge Fund Industry 45 Investors in Hedge Funds 46 What Are Hedge Funds? 48 Hedge Fund Strategies 54 Performance of Hedge Funds 64 PART TWO Evaluating and Selecting Hedge Funds 71 CHAPTER 4 The Skewed Statistics of Hedge Fund Returns: Past Results Are Not Necessarily Indicative of Future Performances 75 Perception of Risks: Numbers and Reality 76 Gaming the Sharpe Ratio 85 Alpha: Holy Grail or Wizard of Oz? 87 Returns of Hedge Funds Revisited 89 Benefits of Hedge Funds Revisited 92 Conclusion 96 CHAPTER 5 Evaluating Hedge Fund Strategies 97 Which Strategies? 97 Is It Uncorrelated, Really? 103 How Neutral Is Market Neutrality? 106 Market Risks of Hedge Fund Strategies 114 Leverage and Hedge Fund Returns 116 Low Correlations: The Good and the Poor 119 Conclusion 121 CHAPTER 6 Picking the Winners 123 Sourcing Hedge Funds 123 Preliminary Screening 125 Strategy Alpha 132 Alpha Generation and Manager Talent 140 Due Diligence 142 Risk and Performance Matrix 145 viii CONTENTS ftoc.qxd 12/28/05 10:48 AM Page viii

Beyond Due Diligence 147 Conclusion 148 CHAPTER 7 Constructing a Portfolio of Hedge Funds 149 Effective Diversification to Reduce Risks 150 How Much in Hedge Funds? 153 How Many Hedge Funds? 157 Know Your Objectives 161 Hedge Fund Portfolios in Practice: Case Examples 165 Quantify Your Judgment 172 Conclusion 175 PART THREE Evaluating Performance and Risks 177 CHAPTER 8 Evaluating the Performance of Your Hedge Funds 179 How Well Is Your Hedge Fund Portfolio? 179 Basic Concepts of Performance Measurement 181 Issues Directly Related to Hedge Funds 182 Market and Hedge Fund Indexes 184 Know Your Hedge Fund Managers or Key Drivers of Returns 187 Hedge Fund Benchmarks in Practice 189 Evaluating Performance: A Heuristic Process 190 Conclusion 192 CHAPTER 9 Buyers Beware: Evaluating and Managing the Many Facets of the Risks of Hedge Funds 195 The Many Facets of Hedge Funds’ Risks 197 Evaluating the Risks of Your Hedge Funds 207 “Left Tail” Risks and Other Quantities 213 Ongoing Risk Management: Risk and Performance Matrix 217 Conclusion 217 Contents ix ftoc.qxd 12/28/05 10:48 AM Page ix

CHAPTER 10 Instant Diversification: Funds of Funds 219 Diversification Benefits of Funds of Funds 220 Fees and the Price of Access 222 Reduced Liquidity 223 Reduced Transparency 223 Generating Alpha: Portfolio Rebalancing 224 Types of Funds of Funds 226 Performance of Funds of Funds 232 Investing with Funds of Funds 235 Conclusion 239 CHAPTER 11 A Practical Guide to Investing in Hedge Funds 241 Information on Hedge Funds 241 Notes 251 Bibliography 265 Index 277 x CONTENTS ftoc.qxd 12/28/05 10:48 AM Page x

Foreword Many misconceptions exist about hedge funds and the hedge fund indus- try. Few investors know that hedge funds have now existed for almost 60 years. Few investors know that the term hedge fund refers more to the legal vehicle (private pool of capital) that houses the underlying strategy than the strategy itself. Most investors view hedge funds primarily as “ab- solute return” investments in which managers seek to obtain extreme posi- tive returns in all market environments. Often the press has portrayed hedge funds as extremely risky investments. In Evaluating Hedge Fund Performance, Dr. Tran attempts to remove these misconceptions. Instead, he emphasizes the risk reduction role of hedge funds when combined with traditional stock and bond investments. Dr. Tran points out that for most of the past 15 years, most hedge fund strategies have underperformed the S&P 500. This should come as little surprise to investors. The lower return achieved by most hedge fund strate- gies is consistent with their lower risk. Most investors fail to realize that return variability of the typical hedge fund is less than that of the typical equity investment. The role of hedge funds as a risk diversifier is a primary focus of this book. The last free lunch of investment rests not in hedge fund investment per se but in combining hedge funds with other traditional assets. The first chapters remind investors that long-term investment does not necessarily remove investment risk. For long time periods, individual asset classes of- ten provide minimal returns. To the degree that a free lunch still exists in investment, it is the result of combining assets with similar return and sim- ilar risk but with low correlation. This results in a portfolio with the same return but with lower variance. Just as important, for two assets with sim- ilar return, the one with the lower variance will achieve the higher long- term return. Hopefully, Dr. Tran’s argument for concentrating on lower risk instead of concentrating solely on higher return will capture the reader’s interest. In the core chapters, hedge fund returns are not presented as providing a higher-return substitute for traditional assets. In contrast, hedge funds are shown often to underperform traditional assets in many market environ- ments. However, the reader is also introduced to the concept of hedge fund xi flast.qxd 12/28/05 10:49 AM Page xi

alpha (to the degree that hedge funds remove their exposure to equity risk, their return may be compared to that of zero-equity-exposure invest- ments). As important, the reduction in market sensitivity also results in hedge funds that have a low correlation with traditional investments and provide true portfolio risk reduction benefits. Since this book’s primary emphasis is on the risk and return behavior of hedge funds, the final chapters emphasize various aspects of hedge fund construction as well as performance analysis and portfolio construction. Dr. Tran reviews some of the basic concepts in performance analysis and portfolio construction and examines the role of hedge funds within an in- vestor’s portfolio. While many of the concepts discussed have been re- viewed in other books, the overview of fundamental risks (management and market based) of hedge fund investment reminds investors that there is no substitute for understanding both the hedge fund strategy and the man- ager behind the strategy. As hedge funds have grown, the number of books attempting to ex- plain the industry and the strategy has also increased. Each book offers a unique view into the hedge fund world. Many of these books review the re- turn potential of hedge funds. Dr. Tran reminds investors that while return is a fundamental part of any investment, return is fundamentally related to risk. Moreover, while investors must understand the fundamental risks of any investment, risk is not rewarded at the asset class level but only at the portfolio level. As a result, assets such as hedge funds that provide diversi- fication are a necessary ingredient to the long-only equity investor. For investors who are looking for an introductory view of the hedge fund industry, this book provides a refreshing look at the pros and cons of investment in general and of hedge funds in particular. Hedge funds are, of course, an evolving industry. As markets evolve, so does our understand- ing. While more advanced readers may wish to spend some time in the footnote sections, individuals wishing an honest introduction to the pros and cons of hedge fund investing will find this book worthwhile. THOMAS SCHNEEWEIS Michael and Cheryl Philipp Professor of Finance Isenberg School of Management University of Massachusetts Director, Center for International Securities and Derivatives Research Managed Futures Association Editor, Journal of Alternative Investments xii FOREWORD flast.qxd 12/28/05 10:49 AM Page xii

Acknowledgments This book would not have been completed without the contributions of so many people. I wish to extend special thanks to Thomas Schneeweis at the Center for International Securities and Derivatives Research; David Brown at Sabrient Systems; Joseph Pignatelli Jr. at The Archstone Partner- ships; Greg N. Gregoriou at the State University of New York (Plattsburgh); Vikas Agarwal at Georgia State University; Joel Press and Lawrence M. Statsky at Ernst & Young; Marc S. Goodman at Kenmar; Duane Roberts at Atlantic Asset Management Partners; William J. Crerend at Evaluation As- sociates Capital Markets; and Scott Beyer at Northern Illinois University. They have read and offered constructive suggestions on the original manu- script. Any remaining errors, however, are mine. My editors, Pamela van Giessen, who encouraged me to write the book, and Bill Falloon, whose pa- tience has sustained me, and the editorial staff, especially Laura Walsh and Mary Daniello, have been most helpful and cooperative. And I am blessed with the love and support from my wife, Nhung; our son, Thuy; and daughter, Heather. Their patience and encouragement have urged me on. VINH Q. TRAN xiii flast.qxd 12/28/05 10:49 AM Page xiii

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Introduction Alfred Winslow Jones started a hedge fund in 1949, pioneering the con- cept and strategy of using hedges to protect his portfolios against mar- ket declines. Though hugely successful and producing handsome returns for his investors, and imitated by others in the subsequent decades, Jones’ idea did not gain much recognition among the investing public in the 1980s and 1990s, who were fixated by the bull market and the popularity of mu- tual funds. In fact, TASS Research identified only 68 hedge fund managers when it began collecting data on hedge funds in 1984. But all of that changed with the bear market of 2000–2002, which witnessed unrelenting stock market declines for the longest period since the crash of 1929. While mutual fund and other traditional investors were reeling in losses, investors in many hedge funds suffered little and sometimes stacked up double-digit percentage gains. As a result, assets under management by hedge funds soared from about $200 billion in 2000 to over $500 billion in 2003, and have reached over $1 trillion by 2005—still small compared to about $8 trillion managed by approximately 8,300 U.S.-based mutual funds but nev- ertheless representing dramatic growth. But even now, reports about hedge funds remain largely negative. Press headlines such as “Hedge-Fund Follies,”1 “Hedge Funds May Give Col- leges Painful Lessons,”2 and “A Health Warning on Hedge Funds”3 clearly are not intended to soothe. The reality is that hedge funds are investments with risk and return characteristics different from traditional stock and bond investments. Many hedge funds have failed miserably. Others have survived and pros- pered, and have provided superior rewards to their investors. Some hedge funds have produced returns that are simply unmatched by mutual funds and other more traditional investments. But the spectacle of the demise of the prominent hedge fund Long-Term Capital Management and similar de- bacles lingers on to taint the overall image of hedge funds. Hedge funds are complicated trading strategies with high turnover and often use complex derivatives structured by financial engineers and math wizards. They also employ leverage to enhance returns, which at the same time exposes them to greater risks. As a result of all these complexities, they require laborious research and in-depth understanding. Investing in xv flast.qxd 12/28/05 10:49 AM Page xv

hedge funds without commitment of time and resources is like driving blind in a storm. Like any other business, the hedge fund industry is sometimes infected with charlatans and mediocrity. But it is also an industry populated by many talented and insightful portfolio managers. As Timothy Geithner, president of the Federal Reserve Bank of New York, remarked, “[hedge funds] can play a beneficial role in the U.S. financial system. They con- tribute to one of the defining strengths of our financial system: the ease with which we match capital to ideas and innovation.”4 In writing this book on evaluating hedge fund performance, Dr. Tran has addressed a difficult topic. But the result is an important and needed work that should be of great value to both individual and institutional in- vestors to have a good understanding of the potential benefits and pitfalls of hedge funds. In this book, Dr. Tran presents a balanced assessment of hedge funds and an evaluation of the returns and risks to be expected from them. In other words, what can investors really anticipate from hedge funds? What methods are used to evaluate them? What characteristics dis- tinguish good funds from bad funds? How does an investor assemble a hedge fund portfolio to achieve target investment goals? Importantly, Dr. Tran discusses in great detail the need to investigate thoroughly a hedge fund before investing with it and to continue to monitor and evaluate it af- ter the investment is made. He also points out the hidden risks of hedge funds that are not adequately measured by the usual statistics such as stan- dard deviation or volatility of returns. Dr. Tran draws on his work and extensive interviews with hedge fund managers and funds of hedge funds, as well as their investors, and from his 20 years of experience in managing hedge fund strategies. In the process, he examines hedge funds in the context of the tenets of modern portfolio theory because it is the foundation on which hedge funds have claimed to possess benefits unobtainable from traditional long-only investments. He also reviews a great deal of research by academics and industry practition- ers, which provide analyses and insight on the track records and long-term prospects of hedge funds. The result of all this research is a tightly structured book with excellent documentation along with sound and well-supported conclusions on in- vesting in hedge funds. DAVID BROWN Chairman and Chief Market Strategist Sabrient Systems, Inc. Santa Barbara, California xvi INTRODUCTION flast.qxd 12/28/05 10:49 AM Page xvi

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PART One A Primer on Hedge Funds Though separated by some 70 years, the crash of 1929 and the bubble burst of 2000 shared some similarities. In the five years between the low in May 1924 and the monthly high in August 1929, the Dow Jones Indus- trial Average, which represented the stocks of the companies of America’s fast-growing industrial economy, had risen by 31.8 percent a year. Half a century later, the NASDAQ was the index that captured the imagination of the investing public with its constituent stocks of the companies in the com- puter, Internet, and information technology sectors. It, too, had risen by an average of 32.8 percent annually during the nearly six years prior to the burst, from the monthly low in June 1994, which had been brought on by the Federal Reserve’s aggressive raising of interest rates, to the high in Feb- ruary 2000. The subsequent decline in the NASDAQ was only marginally less severe, 78 percent as compared to 88 percent in the 1929 crash, and lasted almost as long, 31 months versus 34 months starting in 1929. No one knows how long it will take the NASDAQ to recover to the preburst level of 5,132, although after a year-end rally in 2004 it has gained some 95 percent from the bottom in 2002. However, we do know that two years after the bottom in July 1932, the Dow Jones Industrial Average had risen by 136 percent, and yet it took more than 25 years for the Dow to re- cover to the precrash level. Twenty-five years is a long time to wait, even for patient and committed long-term investors. Long-term investment horizon and diversification to reduce risks are 1 ccc_tran_pt01_1-2.qxd 12/16/05 9:39 AM Page 1

two key concepts in investing. They will be analyzed in Chapter 1 of the first part of the book, a primer on hedge funds. It will be shown how these sound principles have been misapplied and how hedge fund strategies can be positioned as long-term investments to reduce portfolio risks. In Chap- ter 2, the discussion is focused on the potential of hedge funds in reducing risks, not in producing outsized returns. Also, the benefits of hedge funds as a diversification investment and as an alternative investment strategy in bearish and volatile market environments will be discussed in detail. Chap- ter 3 is a review of the hedge fund industry, its investors, the main hedge fund strategies, and how they have performed in past market conditions. 2 A PRIMER ON HEDGE FUNDS ccc_tran_pt01_1-2.qxd 12/16/05 9:39 AM Page 2

CHAPTER 1 The Market Goes Up Forever? The Paradox of Long-Term Investing Jeremy J. Siegel, professor of finance at the Wharton School, started his seminal work Stocks for the Long Run by recounting the investment scheme recommended by John J. Raskob, a senior financial executive at General Motors.1 FLAWS OF LONG-TERM INVESTING According to Professor Siegel, Raskob “maintained that by putting just $15 a month into good common stocks, investors could expect their wealth to grow steadily to $80,000 over the next 20 years.”2 Unfortunately for Raskob, Siegel remarked, his timing was a bit off. Raskob made his recom- mendation two months before the crash in 1929 and was blamed by Sena- tor Arthur Robinson of Indiana “for the stock crash by urging common people to buy stock at the market peak.” A Get-Rich Scheme So, did Raskob provide “foolhardy advice [that] epitomizes the mania that periodically overruns Wall Street”?3 No, according to Siegel. In fact, Siegel postulates, “After 20 years, his or her stock portfolio would have accumu- lated to almost $9,000, and after 30 years, over $60,000. Although not as high as Raskob had projected, $60,000 still represents a fantastic 13 per- cent return on invested capital, far exceeding the returns earned by conser- vative investors who switched their money to Treasury bonds or bills at the market peak.”4 The logic is unassailable and the math is immaculate. It has become the accepted wisdom for a generation of investors and 3 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 3

certainly the progenitors of mutual funds and such financial schemes for the masses. This analysis has been used time and time again by the invest- ment industry to urge investors to buy stocks even when the market was overvalued and poised for a decline, or when the market was just simply tumbling down. Many experts say even buying stocks at a market peak will make you rich. While such a statement may sound appealing, the logic of the scheme rests on two key assumptions that may not always be realistic. A Discipline Few Can Follow The first assumption is that one must invest preset amounts of “$15 a month” every month. The critical consequence of this assumption is that the investors who follow this discipline, which is otherwise known as dol- lar cost averaging, would buy stocks every month without fail, month after month, regardless of the market condition, even when stocks are falling. Such investors therefore would be buying stocks at lower and lower prices as the market weakens, or higher prices as the market strengthens. What if an investor does not or can not? A retiree, for instance, might not put aside funds for additional investments after retirement. Other in- vestors, such as endowments and foundations, whose sources of funds available for new investments are unpredictable or simply not available, might not be able to make additional investments in the face of continuing lower stock prices. Perhaps they simply exercise prudence by not commit- ting additional funds amid uncertainty in the market. Investors who had made a one-time investment of $15 in August 1929 would have seen their investments decrease in value to less than $2 in less than three years, assuming that they had invested in the Dow Jones Indus- trial Average. If these investors managed to hold on to their investments for another 17 years, until 1949, they would have seen their net worth reduced to a mere half of what they had in 1929. Unbelievably, and counter to tra- ditional thinking, they would have suffered a loss of 50 percent for 20 years of long-term investing! Even if any investors had had the where- withal to double their initial investments just after the crash by putting an- other $15 in the market in 1932, which was the year when the Dow hit its lowest point, they would still have had a net loss on their $30 investment after 20 years. In contrast, consider Siegel’s “conservative investors who switched their money to Treasury bonds or bills.” These conservative individuals would have seen their investments more than triple over the course of those same 20 years. 4 A PRIMER ON HEDGE FUNDS ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 4

The second critical assumption is that investors do not take any money out. That is, the initial investments and subsequent investment gains, from both dividends and price appreciation, are left invested in the market. The gains from dividends would be reinvested and the entire proceeds from any stocks that were sold with profits or losses would be plowed back into the market. Since investors did not take the money out, they would not sell into lower prices as the market declines. But what if investors must sell part of their holdings to meet expenses or other obligations while the market goes lower? The reality is that many individuals need income from their investments to live or to maintain their lifestyles. Institutional investors such as endowments, foundations, and pension plans have spending commitments that they must fulfill. They in turn rely on investment returns to meet these financial commitments. Consider what would have been left over if after the initial investment of $15 was made in August 1929, the investors had to take out 5 percent of whatever was left at the end of each year to meet daily living expenses or ongoing spending obligations! Well, for the “conservative” investors who had invested in Treasury bonds, the answer would be the initial $15 capital and more! However, those who had invested in the Dow would have been left with practically nothing. Of course, the market history of the United States has not always been like that of the 1929 crash, although those who invested in NASDAQ stocks in March 2000 might take exception with this statement. In fact, af- ter the crash of 1929, the U.S. stock market embarked on a 70-year expan- sion, punctuated by periods of one- or two-year declines or lackluster performance. During this expansion nothing like the 1929 disaster oc- curred until the bubble of 2000 burst. In this collapse the Dow did not decline as much as it did in 1929. From the top in January 2000 to the bottom in October 2002, the index lost 38.75 percent. As the rally had been fueled by the Internet craze, resembling the stock market hype that preceded the 1929 crash, it was the NASDAQ that took the brunt of the selling. From the intraday high in March 2000, the NASDAQ index lost nearly 78 percent, while displaying the hysteria not unlike the Dow in 1929. In fact, as the collapse progressed, the NASDAQ posted new lows for several months in a row, without respite in between. Then, one- or two-month consolidations were followed by months-long de- clines without intermediate stops. Near the end, there was a losing streak that lasted for five months with progressively lower lows. This time, although there was no soup line like in 1929, the unemploy- ment rate almost doubled to over 6 percent, before posting a moderate de- cline three years later. Three million jobs were lost and at the same time The Market Goes Up Forever? 5 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 5

many retirees whose investment savings had vanished were seeking to re- turn to work. In the meantime, endowments and foundations cut their spending, and pension plans’ unfunded liabilities soared while corpora- tions posted losses or profit declines due to rising contributions to their pension plans to make up for the losses in their equity investments. As long as the market keeps going up, investing in stocks is a winning strategy. The bull market starting in 1982 brought wealth to many in- vestors with relatively little volatility. A small market decline along the way was even desirable, for it would allow investors who had been left out to participate. For those who were fortunate to have been in the mar- ket, the pullbacks were opportunities to increase their investments, which in fact many people did. Many so-called experts maintain that if you buy on the dips, invest for the long term, you can still make money even if you buy at the peak of the market. How? Because the Dow would rise to 36,000, as a couple of authors went on national television to propagate and to promote their best-selling book.5 In fact, Siegel’s book was first published in 1994 and the professor became a much-sought-after market prognosticator. A look back, as many investors now realize, reveals that the 1982–1999 period was the most exceptional in U.S. financial history. Be- tween 1982 and 1999, there was only one losing year, 1990, in the entire 18-year duration; and it was a puny loss at that, a mere –3.1 percent regis- tered by the S&P 500, tucked in between two years of stupendous gains, each exceeding 30 percent. For the entire period, the S&P 500 averaged a rate of return of 19.08 percent a year, and volatility of annual returns was 12.14 percent. This 1982–1999 period’s average return was more than twice the average return of the preceding 18-year duration, and 40 percent less volatile. Despite the strong recovery in 2003, few investors believe that the stock market will see the returns produced in the halcyon years before the Internet bubble burst. Though dismissed as “much too pessimistic” by some experienced investors, such as the head of investments of a $1 bil- lion endowment,6 a number of respected market practitioners believe that stocks will return no more than the mid- to high-single-digit gains going forward. This rate of return range would consist of dividend yield of 1.5 percent, plus 1 to 3 percent due to expansion of price-earnings mul- tiples, and 2 to 4 percent of risk premium.7 As valuation has returned to the prebubble levels following the strong 2003 recovery,8 such predictions of more modest gains seem more likely than expectations of double-digit profits. A greater concern is the likelihood that volatility of returns is bound to increase, if only to the level that had been normal in the prebub- ble years. 6 A PRIMER ON HEDGE FUNDS ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 6

WEALTH-REDUCING EFFECTS OF VOLATILITY The 20-year period prior to the takeoff in 1982 was such a period. There were several years of gains exceeding 20 percent. And the winning streaks typically lasted two or three years in a row. Except for the years of 1973 and 1974, the down years recorded fairly modest losses, 10 percent or less. Certainly this was neither the crash of 1929 nor the bull market of the 1980s. In fact, annually the S&P 500 registered a high-single-digit average return of 8 percent. The volatility of annual returns was 17 percent, ex- actly its long-run historical average. Investors who started putting money in the market in 1962 would have seen a $100 investment rising to $364.77 at the end of 1981, a com- pound annual return of 6.54 percent, certainly not a bad investment com- pared to bonds. Volatility, Wealth, and Income However, the picture becomes a bit more complicated for investors who had to take money out of the market regularly. Table 1.1 provides data helpful in dissecting this period. Column 2 shows the rate of return, including reinvested dividends, of the S&P 500 in each of the 20 years between 1962 and 1981. In column 3, “Nominal Wealth,” the $100 investment in the S&P 500 at the beginning of 1962 is shown to grow to $364.77 in 1981. However, in column 4, it is assumed that at the end of every year, 5 percent of the ending balance is taken out. Thus, at the end of 1962, $4.56 is subtracted from the capital balance of $91.26 (which was the result of the market’s decline of –8.74 percent during 1962; likewise, $5.32 was sold out at the end of 1963). Thus, the capital balance at the end of 1962 was $86.70, as shown in col- umn 5. It then rose to $101.03 due to the market’s gain in 1963, after de- ducting the cash-out of $5.32. In this scenario whereby the investor did not add any new investments after the initial amount in 1962, while regularly taking out 5 percent of the capital at the end of each year, the wealth at the end of the 20-year holding period was $130.76, for a rise of 1.35 percent per year. The inflation rate during this period averaged 6 percent. Thus, in real terms, the growth of the initial investment did not keep pace with in- flation, although the return on the S&P 500 outstripped the rate of infla- tion during this 20-year period of generally rising stock prices. Now, notice how the amounts under column 4, “Available Income,” changed from year to year. Every year, the amounts taken out for spending changed with the investment return. In 1966, the available income was cut by 14.5 percent, even though the investment loss was only –10.05 percent. The Market Goes Up Forever? 7 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 7

After the peak in 1968, available income would not return to this level until four years later, even though the loss in 1969 was relatively modest com- pared to the gains during the previous two years and the gains in the fol- lowing three years. In 1974, available income dropped to $3.98, which is 20.4 percent less than the planned amount of $5, and a drastic decrease of 43.3 percent from the peak in 1972. Importantly, the two-year bear market of 1973–1974 depressed available income such that the peak in 1972 would not be seen again until eight years later, in 1980, despite the market’s stu- pendous gain of 37.16 percent in 1975 followed by an impressive return of 23.57 percent in 1976. Overall, the S&P produced an admirable annualized gain of 14.56 percent in the five years 1975–1979 following the 1973 to 1974 decline. But, following the outsized gain in 1980, the S&P took only a slight pullback in 1981, and available income again dropped below the 1972 peak. In comparison, the gain of 28.69 percent in 2003 following the worst bear market in 70 years seems relatively ordinary. The question is, in the next five years will the stock market be so kind as to produce returns in the mid-teens similar to those seen in post-1974? 8 A PRIMER ON HEDGE FUNDS TABLE 1.1 Stock Returns, Wealth, and Income Average End of Rate of Nominal Available Accumulated Available Year Return Wealth Income Wealth Income 1962 –8.74% $ 91.26 $4.56 $ 86.70 $4.56 1963 22.66 111.94 5.32 101.03 4.94 1964 16.32 130.21 5.88 111.64 5.25 1965 12.35 146.29 6.27 119.15 5.82 1966 –10.05 131.59 5.36 101.82 5.84 1967 23.88 163.01 6.31 119.83 5.98 1968 10.98 180.91 6.65 126.33 6.10 1969 –8.42 165.68 5.78 109.91 6.25 1970 3.93 172.19 5.71 108.52 6.05 1971 14.56 197.26 6.22 118.11 5.90 1972 18.90 234.54 7.02 133.41 6.32 1973 –14.77 199.90 5.69 108.02 6.31 1974 –26.39 147.14 3.98 75.54 5.56 1975 37.16 201.82 5.18 98.42 4.95 1976 23.57 249.39 6.08 115.54 5.08 1977 –7.42 230.89 5.35 101.62 5.54 1978 6.38 245.62 5.41 102.70 5.61 1979 18.20 290.32 6.07 115.32 5.61 1980 32.27 384.01 7.63 144.91 6.37 1981 –5.01 364.77 6.88 130.76 6.86 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 8

Similarly, accumulated wealth, shown in column 5, declined to a disas- trous $75.54 in 1974, which was 24.46 percent below the initial capital. Remember that all of this happened during the intervening 13 years in which the S&P 500 rose by 47.14 percent. Faced with declining spending availability, what would investors do? Sell some of the holdings to make up for the shortfall? In a declining mar- ket? What if investors must sell regardless of the price levels? Investors can moderate the fluctuations in the levels of available in- come from year to year by using some sort of averaging mechanism. Col- umn 6 of Table 1.1 shows the amounts of available income of each year calculated as the simple average of the preceding three years. This averag- ing mechanism reduces the variability in available income, but it does not prevent spending from dropping off unless capital is drawn on.9 It merely delays the day of reckoning. Overall, the high volatility of returns in equity investments, using the S&P 500 as the proxy, leads to consequences that are not wholly palatable to investors who rely on investment returns for future spending, and need a certain level of income to meet periodic spending obligations. One moder- ately down year such as the loss of –8.42 percent in 1969 may cause avail- able income to drop off, taking several years to recover to the previous highs. After a more severe market decline of greater magnitude and length, available income may take many years to return to the previous peak lev- els. Such was the period following the 1973–1974 losses, and should be ex- pected in the aftermath of the 2000 bubble burst. The prospect of continuing declines in available income in many years to come is not fully understood. For example, although the $2.3 billion Duke University Endowment performed better in 2003, its grants fell 6.8 percent from the 2002 level.10 As the president of the endowment com- plained, “The thing a lot of nonprofits don’t understand is that 2003 being a good year doesn’t translate instantly into more money.”11 She continued, “It’s hard to explain how you had a good year but you’re not giving away an equivalently larger amount.” Readers only need to refer to Table 1.1 to see that although the S&P rose 37.16 percent in 1975, users of an averag- ing scheme, which most institutions are, would see average available in- come decline by 10.97 percent. As illustrated in Table 1.1, the recovery of 37.16 percent in 1975 and 23.57 percent in 1976 did not bring available income back to the 1972 level until 1980. As the rally in 2003 was weaker than in 1975, the bub- ble’s losses lasted longer and were more severe, and NASDAQ stocks were surely a part of many investment portfolios, it will take longer for avail- able income to recover to the prior peak levels. This is the issue brought up by Richard E. Anderson, a tenured professor in education finance at The Market Goes Up Forever? 9 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 9

Columbia University, who has been a consultant to college endowments and other institutional investors. He remarked, “College administrators who agonize over the endowment revenue shortfall in the current ’03 and the coming ’04 budget years, simple math shows that without new gifts the spending shortfall could continue for decades [emphasis in the origi- nal].”12 He explained why in Table 1.2. 10 A PRIMER ON HEDGE FUNDS TABLE 1.2 Endowment Value and Spending: The Future Required Spending Amount Available Spendingd Shortfalle Annual Endowment’s for Spendingc (Inflation- (Inflation- March Returna Valueb (Annual) Adjusted) Adjusted) 2001 18.0% $111 $5.00 $5.00 0% 2002 –16.4 88 4.93 5.13 3.90 2003 3.6 86 4.73 5.25 9.90 2004 –17.8 66 3.98 5.38 26.02 2005 10.5 69 3.67 5.52 33.51 2006 10.5 72 3.44 5.66 39.22 2007 10.5 76 3.62 5.8 37.59 2008 10.5 81 4.04 5.94 31.99 2009 10.5 85 4.28 6.09 29.72 2010 10.5 90 4.52 6.24 27.56 2011 10.5 101 4.78 6.4 25.31 2012 10.5 107 5.06 6.56 22.87 2013 10.5 113 5.35 6.72 20.39 2014 10.5 120 5.66 6.89 17.85 2015 10.5 126 5.99 7.07 15.28 2016 10.5 134 6.33 7.24 12.57 2017 10.5 141 6.70 7.42 9.70 2018 10.5 150 7.08 7.61 6.97 2019 10.5 158 7.49 7.8 3.97 2020 10.5 167 7.92 8.19 3.30 2021 10.5 177 8.38 8.4 0.23 a Assuming a portfolio of 75 percent in equities and 25 percent in bonds, and 12 percent return on stocks and 6 percent on bonds. b After spending. c Five percent of the three-year average of the endowment’s value. d Amount of spending required if indexed to inflation assumed at 2.5 percent. e Difference of the preceding two columns. Source: Richard E. Anderson, “Endowment Spending: The Problem Will Be with Us for a While,” Commonfund Commentary, May 2003. ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 10

Anderson remarked, “Therefore, it is not until FY ’13 that budgeted endowment spending reaches the peak ’01 FY spending levels in nominal terms [emphasis is in the original]. Remember, this simulation is using return assumptions that are purposefully and excessively optimistic.”13 He then noted, “The three-year moving average of asset values, shown in the fourth column, does not regain its March ’01 value until March of 2012.”14 If spending is indexed to inflation, assumed at 2.5 percent, the shortfall would last for 20 years, until 2021. Going back to Table 1.1, the average return during 1975–1981 was 13.85 percent. Yet the accumulated wealth declined year after year until 1980 only to decline, in the following year, again below the 1972 peak. All of this may be an exercise in number crunching, but the spending cuts experienced by charitable foundations, the classrooms that were not repaired, the tuition increases, the professors who could not be hired, all of these impacts of the return volatility are very real and have great social and economic consequences. Certainly these impacts are being felt at the na- tion’s endowments and foundations, in pension plans, and by individual retirees. Effects on Retirees, Endowments, and Pension Plans In the report “Foundation Growth and Giving Estimates: 2003 Preview,” the Foundation Center stated that the nearly 65,000 U.S. foundations cut their grants by 2.5 percent in 2003 to $29.7 billion from $30.4 billion in 2002.15 The 902 large and midsize foundations actually reported a larger reduction, 3.2 percent. At the same time, foundation assets lost 6.9 percent between 2002 and 2001, for a cumulative loss of 10.5 percent since 2000. Gifts received by foundations also recorded a sharp drop, nearly 23 per- cent in 2002, from $28.7 billion to $22.2 billion, “reaching the lowest level recorded since 1997.”16 College endowments experienced similar setbacks. According to an an- nual survey by the National Association of College and University Business Officers,17 the average endowment’s assets, at $321.5 million, declined by more than 5 percent between 2002 and 2003 fiscal years, and 23 percent since 2000. However, the median endowment experienced larger drops, to $70 million in 2003 from $80 million in 2002 and $109 million in 2000. At the same time, spending levels as a percentage of endowment assets re- mained essentially unchanged, typically around 5.4 percent. This is be- cause “Once universities get used to a certain amount of money coming from the endowment, it’s really hard to squeeze that back. It’s very painful on campus.”18 Painful as it may be, endowments and educational foundations have The Market Goes Up Forever? 11 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 11

seen much better investment returns than the overall stock market. While on average these institutional investors recorded losses of –6 percent in fis- cal year 2002 (typically ending in June) and –3 percent in the prior year, according to the Commonfund Benchmark Study,19 the broad market in- dexes fared much worse. This was clearly attributable to the significant al- locations to alternative investments, including allocations to hedge funds that have evolved at these institutions. Indeed, alternative investments in- creased from 23 percent in 2000 to 32 percent of endowments’ assets in 2002. This shift came entirely at the expense of U.S. equities, which saw their share drop to 32 percent from 41 percent.20 The impact of market volatility and negative investment returns mani- fests itself in a different way on retirement plans for corporate and public sector employees. When public sector pension plans suffer investment losses, it is the tax- payers who are called on to make up for any resulting unfunded pension li- abilities. For corporate pension plans, negative investment returns hit the bottom line of a corporation’s income statement as well as reduce the value of its pension plan assets. Just before Christmas 2003, General Electric (GE) again came out with a prediction that higher pension costs would dampen earnings to below the target of double-digit rate of growth that GE shareholders were used to in the past. This was not the first time in the past few years that GE disap- pointed shareholders because of pension costs. And GE was not the only corporation that has been presented with this problem of negative returns. General Motors (GM) has watched its pension plan become drastically un- derfunded during the three-year bear market.21 By December 2002, GM had experienced a 23 percent or $19 billion shortfall. In comparison, a typical big corporation’s plan was 18 percent underfunded, according to the actuar- ial firm Milliman & Robertson. As a result, “the pension burden weighed on GM like a rock. Between June 2002 and March 2003, its share price tum- bled 60 percent to $30, in no small measure because investors were worried that the tab for shoring up the pension plan would cut deeply into GM’s rev- enue and profits.”22 At times, a stock market collapse coupled with financial distress may wreak havoc on an entire industry, such as the airlines. Thus, the costs of volatility of investment returns on endowments and pension plans are borne by different groups and are manifested differently. For the endowments, it is the beneficiaries of endowment spending, in- cluding the students who might otherwise receive the hoped-for scholar- ships to attend the colleges of their choice and the professors who might have been hired if endowment spending was not cut. For the private pen- sion plans, the corporations themselves must foot the bills for shortfalls in investment returns. This creates volatility in earnings over and beyond the 12 A PRIMER ON HEDGE FUNDS ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 12

uncertainty attributable to the normal conduct of the business. The market does not like volatility. Stocks of companies that exhibit higher earnings volatility are discounted by the market with lower multiples. Thus, the costs to a corporation that have volatile pension returns are not necessarily limited to a one-time occurrence when charges to the income statement are made. As its stock price is discounted because of volatile pension returns by the market relative to its competitors that have lower earnings volatility, a company’s stock price underperformance tends to persist. To the extent that its operating efficiency and profitability are otherwise competitive or superior, its shareholders are unduly punished by its pension investment strategies. And, not least of all, the efficient allocation of resources in the economy to the most efficient producers may be impaired by pension in- vestment policies that embrace a high level of volatility. Thus, an investment perspective that is focused on high equity returns, with the attendant high volatility, will likely be unable to meet the future investment needs of many institutional and individual investors alike. For most investors, the results of Raskob’s scheme of taking on equity risks in long-term investing, endorsed by finance professors and mutual fund propagators, are anything but steady. The assumptions are flawed and the math is incomplete. The issue of investment volatility and its effects on investors has gained attention on the heels of the bear market. A veteran of the invest- ment business with more than 30 years of experience complained that “it’s hard not to get jittery when stocks start gyrating wildly.”23 He continued, “Few would deny that traditional money management has worked well in the past. But faced with this new order of things, it isn’t working so well anymore. Old tenets such as ‘buy and hold’ and ‘there’s safety in diversification,’ once held as gospel truth, no longer can be counted on to carry the day.”24 He also quoted another investment veteran: “Much of the multitrillion-dollar investment industry is built on half- truths, incorrect interpretations, flawed data, unrealistic expectations, and absolute contradictions. No wonder portfolios based on accepted doctrines have not produced the results intended.”25 If these critics expect the investment industry to change its long-held beliefs, they might have to wait a while. Pure Equity Risk Is Unacceptable The belief in equities and the superior long-term returns of the stock mar- ket reigns supreme. Thus, as posited by a senior investment executive, “Any institution—be it a college, a foundation or a hospital—that intends to be in place to meet the needs of future generations must take investment The Market Goes Up Forever? 13 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 13

risk.”26 What kind of investment risk? The answer is equities, although “compared to the two percent real return currently available on 10-year TIPS,27 an equity premium of two percent was insufficient compensation for the risk. [because]. [a]bandoning equities in favor of bonds to- day when interest rates are at 40-year lows could prove to be very costly to the long-term financial health of our investors. The opportunity costs of not owning stocks could be very large.”28 It is reasonable enough to assume that stocks will outperform bonds, because they have done so in the past over long periods of time. In Stocks for the Long Run, Siegel calculated the returns of stocks versus bonds over different time periods. As shown in Table 1.3, historically, over the long term, stocks have outperformed bonds by wide margins, even in relatively low-inflation periods. However, stocks’ outperformance tended to be more pronounced in times of higher inflation. Is equity risk acceptable? This issue can be looked at from a couple of perspectives. One is the risk premium or the reward for risk taking. Equity returns of mid to high single digits were the averages of the stock market for most periods prior to the takeoff in 1982. Table 1.4 shows the returns on equities over nonoverlapping five-year periods from 1926 to 1980 and for 1982–1999. It is obvious from these data that single- digit returns have been the norms while the 1980s and 1990s have been unusual for equity returns. Assuming that equity returns range about 7 percent over the next 10 years and inflation average 3 percent, real return on equity would be about 4 percent.29 As current real return on 10-year TIPS is already 2 percent, a 2 percent equity risk premium is simply too low. In fact, it is way below the average of 6.5 percent since 1926.30 Would an equity-laden strategy work? Even if stocks outperform 14 A PRIMER ON HEDGE FUNDS TABLE 1.3 Returns on Stocks and Bonds Stocks Long-Term Government Bonds Dividend Period Nominal Real Yield Nominal Real CPI 1926–2001 10.2% 6.9% 4.1% 5.3% 2.2% 3.1% 1946–2001 11.6 7.1 3.8 5.5 1.3 4.1 1966–1981 6.6 –0.4 3.9 2.5 –4.2 7.0 1982–1999 17.3 13.6 3.1 12.0 8.4 3.3 1982–2001 14.1 10.5 2.9 12.0 8.5 3.2 Source: Jeremy J. Siegel, Stocks for the Long Run: The Definitive Guide to Finan- cial Market Returns and Long-Term Investment Strategies, 3rd ed. (New York: McGraw-Hill, 2002), p. 13 and p. 15. ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 14

bonds as they historically have, it is most unlikely that the endowments that rely on equities producing 7 percent returns would achieve their objec- tive of “meeting the needs of future generations.” Equity volatility was much lower during the bull market of the 1980s and 1990s than it had been in the past. Between 1982 and 1997, equity volatility was 13.1 per- cent, a mere two-thirds of the volatility experienced during the 25 years prior to the bull market. If equity returns are in the single digits coupled with volatility returning to the historical norms in the high teens, endow- ments and pension plans that rely on equities are likely to be in much worse shape in the future than Anderson’s calculations may indicate. Remember that in Anderson’s calculations shown in Table 1.2, stocks are assumed to produce 12 percent annually year in, year out. If endow- ments and pension plans remain heavily exposed to equities, whose returns are likely to be stuck in the single digits, and total portfolio return is re- duced to 6 percent, or less than three-fifths of Anderson’s assumptions, without new funding endowments’ spending and asset values will be un- likely to return to the 2001 level for decades to come. These results are even more astonishing considering that in these calculations, out of 21 The Market Goes Up Forever? 15 TABLE 1.4 Stock Returns in the Long Run Period Nominal Real 1926–1930 5.49% 8.33% 1931–1935 3.13 5.46 1936–1940 1.11 0.71 1941–1945 16.76 11.23 1946–1950 9.41 2.67 1951–1955 20.84 19.14 1956–1960 9.78 7.58 1961–1965 13.25 11.85 1966–1970 3.34 –0.50 1971–1975 3.21 –3.14 1976–1980 14.01 5.50 1982–1999a 17.30 13.60 a 1982–1999 data from Jeremy J. Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, 3rd ed. (New York: McGraw-Hill, 2002), p. 13. Source: Charles P. Jones and Jack W. Wilson, “The Changing Nature of Stock and Bond Volatility,” Financial Analysts Journal, January/February 2004, p. 102. ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 15

years 18 have stellar returns, and in only 2 years does the investment port- folio experience a loss in value. For an endowment, a higher volatility of return implies that there is a greater risk that the endowment might have to sell holdings at lower prices to raise cash in order to meet its spending needs. For a pension plan, the greater volatility of returns implies that there is a lesser predictability in the amount of contributions that a corporation would have to make every year to its pension plans. Higher earnings volatility implies higher volatility of stock prices. The resulting market discount of price-earnings multiples would have a long-lasting depreciative effect on the corporation’s stock prices, therefore undermining shareholders’ value. Thus, from the perspective of investors who have periodic commit- ments, be it that they are retirees or wealthy families who need investment income to maintain their lifestyles, or endowments and foundations that have committed spending, or pension plans whose yearly contributions af- fect companies’ corporate profits, the question is how to reduce the volatil- ity without sacrificing the returns that they have been used to. The answer clearly does not lie with pure equity risks. Fortunately, investors have re- discovered an alternative investment strategy that is designed to reduce in- vestor portfolio risks and provide protection in market downturns while at the same time being capable of generating returns competitive with equities in the long run. It has been pioneered and practiced for more than 50 years and it is called hedge funds. Unlike traditional investment strategies, hedge funds engage in short selling in order to partly or fully offset their long po- sitions in stocks and bonds. As such, they seek protection against market declines that potentially may bring losses to their investments on the long side, and thereby reduce volatility of returns. DIVERSIFICATION TO REDUCE RISKS Investors are aware of the volatility of equity-only portfolios. To reduce risks, the traditional strategy is diversification. Thus, institutional portfo- lios typically include both stocks and bonds. Within the equity sectors, portfolios are diversified in terms of market capitalization of individual se- curities, or in terms of styles such as value versus growth, as well as with international stocks. However, it is commonly overlooked that the degree of correlation of the assets in a diversified portfolio is critical to achieving the objective of reducing risks by diversification. In general, if two assets have similar stan- dard deviation and perfect correlation—that is, the correlation coefficient is equal to 1—diversification with these two assets does not reduce risks in 16 A PRIMER ON HEDGE FUNDS ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 16

any way. If one of the two assets has higher volatility, risk-averse investors would be better off investing all capital in the lower-volatility asset; adding the higher-volatility asset would only increase the risk. If the two assets have perfect negative correlation—that is, they move in opposite directions and their correlation coefficient is equal to minus 1—it is possible to create a riskless portfolio combining these two assets, even though the two assets may be highly volatile. As the correlation coefficient, which has a range from minus 1 to plus 1, increases, the risk-reducing benefits of diversifica- tion decline. At a value of plus 1, risk-reducing benefits of diversification disappear. Not with Correlated Assets This has been what happened with traditional long-only equity portfolios in recent history. Though they contained stocks in different equity sectors, diversification neither reduced volatility nor increased returns. Table 1.5 shows the correlation matrix, volatility, and returns of the various stock indexes, including small-cap and mid-cap stocks as well as growth and value styles, during January 1979–May 2004. Except for the Morgan Stanley Capital International (MSCI) index, they all showed very high degrees of correlation. All of these indexes also had similarly high volatility. Due to near-perfect correlation, diversification among these eq- uity sectors would not reduce portfolio risks. Furthermore, during this 25- year period, the S&P, MSCI, Russell 3000, and Russell Mid Cap produced very similar returns. Also, all the Russell indexes produced similar return ranges between June 1995 and May 2004. Overall, a strategy of diversification among highly correlated equity sectors with the objectives of reducing risks and/or achieving higher re- turns was futile during the past 25 years. Depending on the exact alloca- tion strategies with different weightings in different equity sectors, diversification not only did not lower volatility, but it could have reduced returns as well. This would be especially painful if large allocations were made to international stocks. In Table 1.5, the MSCI World ex-U.S. index represents international stocks. Its correlation with the S&P 500, Russell 3000, and Russell Mid Cap was about 0.6 during the period from January 1979 to May 2004, somewhat lower than the correlations of the domestic indexes among themselves. Taken at face value, this would suggest some benefit in interna- tional diversification in terms of risk reduction, though not in enhancing returns. Closer scrutiny, however, reveals a different picture. During the three-year bear market from April 2000 to March 2003, correlation be- tween the S&P and the MSCI went up sharply to 0.85. At the same time, The Market Goes Up Forever? 17 ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 17

TABLE 1.5 Equity Correlations MSCI Russell Annualized Return S&P World Mid 1/1979– 6/1995– Index 500 Ex-U.S. 3000 Cap Growth Value Volatility 5/2004 5/2004 S&P 500a 1 15.35% 10.14% 8.60% MSCI World ex-U.S.a 0.60 1 15.54 10.12 4.10 Russell 3000a 0.99 0.60 1 15.58 10.15 8.60 Russell Mid Capa 0.93 0.58 0.96 1 16.59 11.95 10.76 Russell 3000 Growthb 0.94 0.77 0.95 0.95 1 20.49 NA 7.08 Russell 3000 Valueb 0.89 0.72 0.89 0.85 0.71 1 14.79 NA 9.18 a Period between January 1979 and May 2004. b Period June 1995 and May 2004. Source: PerTrac. 18 ccc_tran_ch01_3-22.qxd12/16/059:39AMPage18

volatility of MSCI remained at the 25-year level of 15.5 percent. Particu- larly painful was the fact that during the global bear market, the MSCI lost 47 percent compared to 43 percent by the S&P. Thus, international diversi- fication in the bear market did not help reduce volatility nor protect in- vestors from sharp declines. The failure of international diversification to reduce risks has gained attention in the popular press. In a New York Times column, Mark Hul- bert commented that “academic studies have found that the performance of foreign stocks and domestic stocks tends to be more highly correlated— more closely linked—when domestic stocks are declining than when they are rising. This dual relationship has several unfortunate consequences. It means that foreign stocks provide relatively little risk reduction to a port- folio when it needs it the most: when most of the holdings are declining. It also means that international diversification provides the bulk of its risk reduction when domestic stocks are rising, when investors don’t really need it.”31 Diversification with Fixed Income Another diversification strategy is mixing stocks and bonds. Since bonds have less volatility and a low correlation with stocks, a stock-and-bond portfolio would have lower volatility than a stock-only portfolio. In Table 1.6, for the period between January 1979 and May 2004, the Lehman Aggregate Bond index showed a correlation of 0.24 with the S&P (its correlation with the MSCI World index ex-U.S. was also a low 0.17). Its volatility was 6.3 percent, significantly lower than those of the two stock in- dexes. If the Lehman index and S&P had perfect correlation, combining equal portions of these two indexes in one portfolio would result in a port- folio volatility of 10.82 percent. However, because their correlation was only 0.24, the volatility of this 50/50 portfolio was reduced to 8.4 percent, The Market Goes Up Forever? 19 TABLE 1.6 Correlations of Stocks and Bonds, January 1979–May 2004 Lehman MSCI Aggregate S&P World Standard Annualized Index Bond 500 ex-U.S. Deviation Return Lehman Aggregate Bond 1 6.30% 9.28% S&P 500 0.24 1 15.35 10.14 MSCI World ex-U.S. 0.17 0.60 1 15.54 10.12 Source: PerTrac. ccc_tran_ch01_3-22.qxd 12/16/05 9:39 AM Page 19

or 22.4 percent lower. Interestingly enough, there is a minimum-risk portfo- lio consisting of 92.8 percent in the Lehman index and 7.2 percent in the S&P. This portfolio has a volatility of 6.05 percent, which is lower than that of the Lehman index. However, return is higher than that of the Lehman in- dex by a fractional 0.04 percent to 9.34 percent. Such are the diversification benefits with low-correlation assets. During the January 1979–May 2004 period, the equity bear market and the simultaneous drops in interest rate allowed the bond index to pro- duce returns that were only slightly lower than those of the two stock in- dexes. However, in the 20 years between January 1980 and 1999, the Lehman index underperformed the U.S. and international stock indexes by almost 4 percent per annum. In this period, the MSCI and S&P 500 in- dexes generated 13.7 and 13.9 percent a year respectively, while the Lehman produced 10 percent. In Stocks for the Long Run, Jeremy Siegel documented that bonds consistently underperformed stocks in both low- and high-inflation periods. In general, if stocks outperform bonds as experienced prior to the bubble burst, diversifying stock portfolios with bonds would bring portfolio returns to levels below those of equity-only portfolios, though with lower volatility. However, if equities produce only single-digit returns, diversification with bonds might not severely impact the returns of the resulting portfolios. LONG-TERM INVESTING WITH LOW-CORRELATION ASSETS AND DOWNSIDE PROTECTION As stocks outperformed bonds by wide margins during the bubble years, expectations of high returns among individual and institutional investors alike kept ratcheting up and allocations to equities reached extreme levels. Many corporate pension plans shifted 75 percent and more of their assets to stocks; some still maintain all-stock portfolios to this day. The virulent bear market and large losses suffered by investors with overly large expo- sures to equities have created an opportunity to heed some basic realities of investment. First, diversification among high-correlation assets is not diversifica- tion to reduce risks. Simply adding higher-risk investment