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AIMA'S ROADMAPTO HEDGE FUNDS
NOVEMBER 2008
AUTHORED BYALEXANDER INEICHEN,ALTERNATIVE INVESTMENTSOLUTIONS, UBS GLOBALASSETMANAGEMENTCO-AUTHORED BYKURTSILBERSTEIN,CALPERS
COMMISSIONED BYAIMA’S INVESTOR STEERING COMMITTEE
IN ASSOCIATION WITH CAIA
 
AIMA’S ROADMAPTO HEDGE FUNDS - NOVEMBER 2008
2
Table of content
Foreword
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3
Executive Summary
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5
Preface
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7
What exactly is a hedge fund?
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9Introduction and definition
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10The hedge fund industry
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
13
Performance
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
13
 Assets under management
. . . . . . . . . . . . . . . . . . . . . . .
16
Flow of funds
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20Concluding remarks:
What exactly is a hedge fund? 
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
21
Demystifying hedge funds
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23Myths and misconceptions
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24
Myth: hedge funds gamble
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24
Myth: hedge funds always hedge
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25
Myth: hedge funds are risky 
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26
Myth: hedge funds are speculative
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26
Myth: hedge funds charge high fees
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27
Myth: hedge funds generate strongreturns in all market conditions
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30
Myth: the lesson of LTCM is not to investin hedge funds
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32
Myth: hedge funds increase systemic risk of  financial markets
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33
Myth: selling short is the oppositeof going long
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34
Myth: there is no absolutereturn revolution
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35Concluding remarks:
demystifying hedge funds
. . . . . .
37
How do hedge funds work?
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
39Hedge fund investing
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
40
Investment process
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40
- Manager selection and monitoring
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41
- Portfolio selection and monitoring
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43
The role of prime brokers
. . . . . . . . . . . . . . . . . . . . . . . .
50
Fund of hedge funds
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52
- Investment philosophy of a fund of funds manager 
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53
- Risk management experienceand other intangibles
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
53Concluding remarks:
hedge fund investing
. . . . . . . . . . . . .
62
Strategies
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
63Classifying hedge funds
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
63Return, volatility, Sharpe ratios and all that
. . . . . . . . .
68Valuation
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
71Leverage
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
72Liquidity
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
76Fat tails
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
79Concluding remarks:
strategies
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
87
Why invest in hedge funds
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89Value proposition of hedge funds
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90
 Active versus passive management
. . . . . . . . . . . .
90
The Fundamental Law of Active Management
. .
95
The idea of asymmetric returns
. . . . . . . . . . . . . . . .
97
 Active risk management
. . . . . . . . . . . . . . . . . . . . . . . . .
101
- Applicability and adaptability of skill
. . . . . . . . . . .
101
- Intellectual property versusadaptability of skill
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
103Concluding remarks:
value proposition of hedge funds
. . . . . . . . . . . . . . . . . . . . . . .
105From relative to absolute returns
. . . . . . . . . . . . . . . . .
106
Managing tracking risk versus total risk
. . . .
106
What exactly is risk? 
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
110
- The boiling frog syndrome
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110
- Risk versus uncertainty 
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
112
What exactly is risk management?.
. . . . . . . . . .
113
- The musical chairs effect
. . . . . . . . . . . . . . . . . . . . . . . . .
114
- Prevention versus cure
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
116
Compouding matters
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
120Concluding remarks:
 from relative to absolute returns
. . . . . . . . . . . . . . . . . . . . . . .
123
Closing remarks
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
125Hedge funds: risky game or game of risk?
. . . . . . .
126
Appendix 1: the origins of hedge funds
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131Some technical aspects about tail risk
. . . . . . . . . . .
136Failure, survival and the AdaptiveMarket Hypothesis
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142Working example of how leveragecan be used
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147
Appendix 2: Practical next steps
. . . . . . . . . . . . . . . . . . . . . .
148
Appendix 3: Glossary and references
. . . . . . . . . . . . . . . .
153
Appendix 4: About AIMA,the sponsors and authors
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163
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AIMA’S ROADMAPTO HEDGE FUNDS - NOVEMBER 2008
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One of the great things about hedge funds is that they have provided a field day for academicresearchers to write scholarly articles on their risks and returns. Yet, for all of this scholarship,a practical roadmap to hedge funds has remained elusive. Until now.On behalf of AIMA’s Investor Steering Committee, Alexander Ineichen has provided a referenceroadmap that breaks down the world of hedge fund investing into fundamental and usefulconcepts. Alexander and Kurt Silberstein, who has contributed to this publication arepractitioners. Kurt’s “day job” requires him to invest capital in the hedge fund world whilstAlexander’s role is to provide in-depth analytical insight into the hedge fund industry.Therefore, they speak with the wisdom and experience of those whose livelihoods actuallydepend upon making good hedge fund manager selections. This book reflects theiraccumulated knowledge.In the first section of the roadmap, there is an introduction to and definition of hedge fundstogether with information on its growth, the overall returns, breakdown of strategies andmanager locations, flow of funds and comparison to other asset classes. This section answersthe fundamental question: are hedge funds worth the effort? The key is to provide a macroperspective for broader asset allocation decisions.The second section of the roadmap hits squarely at the myths of hedge funds. Unfortunately,the hedge fund industry still remains poorly understood. Too many “myths” surround thisindustry and this leads to scepticism and avoidance. Alexander charges right at the myths,labelling them and explaining their lack of empirical support or theoretical grounding. Forexample, one myth is that hedge funds hedge market risk. Certainly, some hedge funds do justthat, but many hedge fund styles take on calculated market risks with the expectation ofearning superior returns than the market. More specifically, most hedge funds hedge onlycertain risks that they do not believe offer a sufficient return premium while loading up onrisks where they believe the return premium is undervalued or will exceed the market return.The key to demystifying hedge funds is to understand their fundamental investmentphilosophy. Once the myths are removed, the reader will be much more educated as to thebenefits and risks of hedge fund investing.Section three gets down to the nuts and bolts of building a hedge fund program as well asidentifying the main strategies. The reader is taken through a pragmatic review of how tobuild a hedge fund program from the ground up. It is clear from this section that they drawon their personal experience at building two of the largest hedge fund programs in theinvestment world. However, most investors do not have the internal resources necessary tobuild their own hedge fund program and, therefore, must rely upon a fund of hedge fundsinvestment. This limitation is recognised and, consequently, the section provides an excellentdiscussion on the benefits of funds of hedge funds. Then, there being no uniform classification
Foreword
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