1. INTRODUCTION There is no exact definition to the term “Hedge Fund”; it is perhaps undefined in any securities law.

There is neither an industry wide definition nor a universal meaning for “Hedge Fund”. For general purposes, hedge funds, including fund of funds, can be considered as unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, nonsecurities and derivatives) and are not subject to the same regulatory requirements as mutual funds. The first hedge fund was set up by Alfred W. Jones in 1949, though the term did not gain popularity until 1960s. Jones wanted to eliminate a part of the market risk involved in holding long stock positions by short-selling other stocks. He thereby shifted most of his exposure from market timing to stock picking. Jones was the first to use short sales, leverage and incentive fees in combination. In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi-manager hedge fund. In the mid 1950's other funds started using the short-selling of shares, although for the majority of these funds the hedging of market risk was not central to their investment strategy. In 1966, an article in Fortune magazine about a "hedge fund" run by a certain A. W. Jones shocked the investment community. During the 10-year period from 1955-1965 Jones' fund returned 670 percent. Apparently, the fund had outperformed all the mutual funds of its time, even after accounting for a hefty 20% incentive fee. The first rush into hedge funds followed and the number of hedge funds increased from a handful to over a hundred within a few years. Thus has started the hedge fund industry, which though initially faced a lot of problems with inexperienced newcomers gradually picked up its admiration and is now considered to be the fastest growing segment of the financial markets. The industry with an average fund size of US $ 125 mm and growing at an astounding growth rate not just while reaching out to new customer segments – institutions, pension


funds and endowments – has now attracted even the retail investor through its fund of funds. But there are also claims that with the increase in the craze for the hedge funds, a lot of new managers have come in with insufficient experience and are misusing the term ‘hedge funds’. How true is this? Is the outstanding return generating ability of the hedge funds really gone down? Is it the trend that everyone needs to catch up to or the beginning of the end of a legend? There arises the necessity to analyse the industry performance and to understand how the industry had performed and is performing in the current times. The project employs sophisticated techniques, the results of a lot of academic works, to analyse the performance of the hedge funds industry in an efficient manner, escaping any underlying biases, under the constraints of limited resources of time, information and of course the ability of comprehension. The next section deals with understanding the growth of the hedge fund industry and the probable reasons for the same. Section 3 explains the process and path behind the performance analysis. Section 4 details the performance analysis using different observations. Section 5 concludes the report talking of the worries about the future. Four appendixes attached help understand some background information about the hedge funds, the indexes involved in the analysis and the mathematics behind skewness and kurtosis.


2. GROWTH OF HEDGE FUNDS The term “hedge funds” first came into use in the 1950s to describe any investment fund that used incentive fees, short selling, and leverage. Since then, the industry of hedge funds kept growing. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments and engage in a wider variety of investment strategies. Today, in addition to trading equities, hedge funds may trade fixed income securities, convertible securities, currencies, exchange – traded futures, over the counter derivatives, futures contracts, commodity options and other non-securities investments. However, hedge funds today may or may not utilize the hedging and arbitrage strategies that hedge funds historically employed, and many engage in relatively traditional, long only equity strategies. This must make it clear as to why most of the discussions about hedge funds, including this, start with the statement ‘There is no exact definition to the term “Hedge Fund”’*.

2.1. Number of Hedge Funds and Total Assets As the hedge remains it to is fund nonvery
$900.00 $800.00 $700.00 $600.00 $500.00 $592.00 $546.00 $408.00 $400.00 $300.00 $200.00 $100.00 $0.00 $35.00 $0.50 $1.00 $3.00 $2.00 $20.00 $76.00 $324.00 $221.00 $130.00 $795.00

industry regulated, difficult

Hedge Fund Assets (US $Billions)


exactly the size of the industry. But there are a few industry information sources market that help the the estimate

statistics of the industry. One such source helps understand the evolution.

Jan-50 Jan-60 Jan-71 Jan-74 Jan-87 Jan-92 Jan-95 Jan-97 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04

Figure 2.1: Growth in the Hedge Fund Assets from Jan 50 to Jan 04


For more details about Hedge Funds refer Appendix A.


Very clearly, from the above graph, hedge funds have attracted significant capital over the last decade, apparently triggered by successful track records. The global hedge funds volume has increased at an astonishing growth rate, from US $20 billion in 1987 to US $795 billion in 2004. Estimates of new assets flowing into hedge funds exceed US $25 billion on average for the last few years. By 2008, hedge fund assets have been predicted to reach the US $ 2 trillion mark. This makes hedge funds as the sector showing the most growth in the entire financial services arena.
Number of Hedge Funds

The global hedge fund volume accounts for about 1% of the combined global equity and bond market. The number of hedge funds has also increased rapidly from 100 to about 7000 between 1987 and 2004.

8000 7000 7000 6000 5000 4000 3000 2080 2000 1000 0 1 30 140 30 100 880 3000 4000 3500 4800 5500 5700

Jan-50 Jan-60 Jan-71 Jan-74 Jan-87 Jan-92 Jan-95 Jan-97 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04

Figure 2.2: Growth in the Number of Hedge Funds from Jan 50 to Jan 04


2.2. Prospective Markets for More Growth In Europe the overall hedge fund volume is still small with about US $ 80 billion in 2003, which accounts for about 11% of the global hedge fund volume. The number of hedge funds in Europe is about 600. Within Europe, hedge funds have become particularly popular in France and Switzerland where already 35% and 30% of all institutional investors have allocated funds into hedge funds. In 2003, Italy’s hedge fund industry nearly tripled in size as assets grew from Euro 2.2 billion to Euro 6.2 billion. Germany is at the lower end with only 7% of the institutional investors using hedge funds. But the Investment Modernization Act, may well trigger rising interest from German investors. Overall, hedge fund assets are estimated to increase ten fold in Europe over the next 10 years. The acceptance of hedge funds seems to be growing through out Europe, as investors have sought alternatives that are perceived as less risky during the last three years equity bear market. This trend is also evident in Asia, where hedge funds are starting to take off. According to AsiaHedge magazine, some 150 hedge funds operate in Asia, till year 2002 which together managed assets estimated at around US $ 15 billion. In Japan, too hedge funds are becoming the focus of more attention. Recently, Japan’s Government Pension Fund one of the world’s largest pension fund with US $ 300 billion has announced plans to start allocating money to hedge funds. Industry participants believe that Asia could be the next region of growth for the hedge fund industry. The potential of Asian hedge funds is well supported by fundamentals. From an investment perspective, the volatility in the Asian markets in recent years has allowed long-short and other strategic players to outperform regional indices. The relative inefficiency of the regional markets also presents arbitrage opportunities from a demand stand point US and European investors are expected to turn to alternatives in Asia as capacity in their home markets diminish. Further, the improving economic climate in South East Asia should help foreign fund managers and investors to refocus their attention on the region. Overall, hedge funds look set to play a larger role in Asia.


2.3. Probable Reasons for Growth There are a number of factors behind the rising demand for hedge funds. While high net worth individuals remain the main source of capital, hedge funds are becoming more popular among institutional and retail investors. Funds of funds (hedge funds) and other hedge fund-linked products are increasingly being marketed to the retail investors in some jurisdictions. Public funds, endowments, and corporate sponsors have all increased their allocations to hedge funds within the context of an increased allocation towards alternative investments more generally. This move towards increased investments in real estate/private equity/hedge funds (alternative investments) is driven by the need for a higher return to compensate for the expected lower returns from more conventional investment strategies focused on US bonds and equities. The unprecedented bull run in the US equity markets during the 1990s swelled investment portfolios this lead both fund managers and investors to become more keenly aware of the need for diversification. Hedge funds are seen as a natural “hedge” for controlling downside risk because they employ exotic investments strategies believed to generate returns that are uncorrelated to asset classes. Until recently, the bursting of the technology and telecommunications bubbles, the wave of scandals that hit corporate America and the uncertainties in the US economy have lead to a general decline in the stock markets worldwide. This in turn provided fresh impetus for hedge funds as investors searched for absolute returns. The growing demand for hedge fund products has brought changes on the supply side of the market. The prospect of untold riches has spurred on many former fund managers and proprietary trades to strike out on their own and set up new hedge funds. With hedge funds entering the main stream and becoming ‘respectable’, an increasing number of banks, insurance companies, pension funds, are investing in them. There is also a clear desire among this investor base to be more focused on absolute-return strategies rather than relative return. Given the current level of allocations most of these large long-term investors have moved towards alternative investments, and their professed long-term target allocation, the flow of funds to these asset classes will remain strong. 6

3. BEHIND THE PERFORMANCE ANALYSIS 3.1.Data One of the most common ways to comprehend and appreciate the performance of something is to consider its historical data. As our subject of concentration here is the hedge fund industry as a whole, it would be brilliant if the historical data involves all the hedge funds in the industry. But unfortunately that is not possible because of lack of easy availability of all the data. Since hedge funds do not register with SEC their actual data cannot be independently followed and thus the only way one can expect the data is through self-reporting by the hedge fund which would further lead to non-uniformity in the database. These hedge funds though, for varied reasons, report their performance to many information sources, which disseminate the same to the market, helping a big lot of investors and researchers. Most of these sources also calculate indexes to indicate the movement of the industry as a whole. Thus, for our purpose, these hedge fund indexes are chosen as the most logical way to understand the industry performance. Seven such hedge fund indexes have been obtained from their respective websites. They include Altvest, CSFB/Tremont, EACM-100 Onshore, HFR, Hennessee, MSCI Hedge and VAN*. But the very fact that there are so many hedge fund indexes leaves us with the problem of ‘which to use’. Added to that, many research reports indicate that these hedge fund indexes have biases, making them, individually, unreliable.


For more details about Hedge Fund Indexes refer Appendix B.


3.2.Biases in Hedge Fund Indexes The hedge fund indexes have been set up to provide the rigorous data and analytics that both managers and investors increasingly demand for measuring performance and risk in this rapidly growing asset class. However, there are inherent problems in compiling a benchmark for the hedge fund industry, specifically including the presence of various biases in the databases. There are three main sources of difference between the performance of hedge funds in the database and the performance of hedge funds in the population (see Fung and Hsieh (2001a)). Survivorship bias: This occurs when unsuccessful managers leave the industry, and their successful counterparts remain, leading to successful managers only being counted in the database. The inherent problem is that a database overestimates the true returns in a strategy, because it only contains the returns of those that were successful, or at least of those that are currently in existence. Selection bias: This occurs if the hedge funds in the database are not representative of those in the universe. Information on hedge funds is not easily available. This is because hedge funds are often offered as a means of private placement, and no obligation of disclosure is imposed in the US. As a result, database vendors collect information on those hedge fund managers who cooperate only. Besides, when a hedge fund enters a vendor database, the fund history is generally backfilled. This gives rise to an instant history bias (Park (1995)). Since we expect hedge funds with good records to report their performance to data vendors, this may result in upwardly biased estimates of returns for newly introduced funds Researches indicate that these biases are not insignificant and cannot be neglected. Fung and Hsieh (2000), using the TASS database, find that the surviving portfolio had an average return of 13.2 % from 1994 to 1998, while the observable portfolio had an average return of 10.2 % during this time, from which, there is a 3% survivorship bias per year for hedge funds (a similar number is obtained in Park et al. (1999)). The attrition rate, defined as the percentage of dead funds in the total number of funds has been reported by Agarwal and Naik (2000b) as 3.62%, 2.10% and 2.22% using quarterly, half


yearly and yearly returns, which is consistent with an average annual attrition rate of 2.17% in the HFR database reported by Liang (1999) for 1993-97. These attrition rates are much lower than the annual attrition rate of about 14% for offshore hedge funds in 1987-96 reported by Brown, Goetzmann and Ibbotson (1999) and 8.3% in the TASS database in 1994-98 as reported by Liang (1999). Overall, it is probably a safe assumption to consider that these biases account for a total approaching at least 4.5% annually (see Park, Brown and Goetzmann (1999) and Fung and Hsieh (2000))

Figure 3.1: Survivorship, Selection Biases in Hedge Fund Returns


3.3.Pure Style Index As the above researches indicate, in the presence of many different competing indexes, one may be at a loss to decide which one to use for benchmarking the performance of active or passive managers. There are essentially two possible approaches to the problem. One approach involves carefully studying the methods and data used by each index provider, and coming up with a qualitative assessment of which is doing the best job. The problem is that there is no clear and definitive judgement that one can make on the subject. All existing indexes have both advantages and drawbacks. Second approach. Given that it is impossible to come up with an objective judgement on what is the best existing index, a natural idea consists of using some combination of competing indexes, a pure style index, to reach a better understanding of what the common information would be. In other words, searching for some notion of “intersection” of competing indexes. One straightforward method for obtaining a composite index based on various competing indexes would involve computing an equally weighted portfolio of all competing indexes. This would obviously provide investors with a convenient one-dimensional summary of the contrasted information contained in competing indexes. In particular, because competing hedge fund indexes are based on different sets of hedge funds, the resulting portfolio of indexes would be more exhaustive than any of the competing indexes it is extracted from. For our purposes, this method has been considered efficient. The pure style index thus calculated then requires some base index to understand and compare the performance with. As hedge funds are considered alternative investments (non-traditional investment with potential economic value), it has been considered logical to compare the index with a more traditional investment – equity. In the process, it can also be understood if the high fees charged by the hedge funds are worth it. The equity market provides the investor base once again with a range of indexes, creating the problem of ‘which to use’. But unlike earlier, we do not calculate an index that 10

represents all the market indexes. Instead the pure style average index is compared to the different market indexes individually. The equity market indexes thus chosen and what they specifically represent are shown in the table below.

Equity Market Index Dow Jones Industrial Average (DJIA) MSCI Europe, Australasia and Far East Standard & Poor’s (S&P) 500 Wilshire 5000 Russell Midcap Russell 2000 Russell Microcap

Represents 30 large frequently traded stocks 21 developed markets outside North America Top 500 US corporations by market capitalisation Entire US stock market – all public companies Mid-cap segment of US equity market Small-cap segment of US equity market Microcap segment of US equity market

Table 3.1: Market Indexes considered in the Analysis and their respective segments

As can be seen from the above table, the market indexes* have been carefully chosen to help compare the hedge fund universe with different segments from large-cap to microcap and ultimately the major equity markets.


For more details about Market Indexes refer Appendix C.


3.4.Methodology For the hedge fund indexes, the problem of ‘which to use’ was given a solution of calculating a pure style index to rectify the biases discussed earlier. The pure style index has been created in its simplest form – average. Six different hedge fund indexes – Altvest, CSFB/Tremont, EACM-100 Onshore, HFR, Hennessee and VAN – involving monthly returns from January 1996 to December 2005 have been used to calculate the pure style average index. Sharpe Ratio, the most widely used traditional risk-adjusted performance measure, has been considered as to compare the performance of the pure style index against the broad equity market indexes. The Sharpe ratio can be defined as a risk-adjusted measure developed by William F. Sharpe, calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

The above formula gives monthly Sharpe ratio, which can be annualized by multiplying the result with square root of 12. The risk-free return for our purposes has been considered as the return of 90 day T-bill return. This Sharpe ratio has many desirable properties. However it is not flawless. It is leverage invariant; it does not account for correlations; nor can it handle iceberg risks lurking in the higher moments. Worse yet, it can be ‘gamed’ by truncating the right tail of the returns distribution at the expense of a fat left tail (the periodic crashes). It has also been researched and proved that high Sharpe ratios in hedge funds often represent a trade-off for higher moment risk.


One line of thought is to salvage the Sharpe ratio’s relevance while retaining the familiar form by replacing standard deviation in the denominator with an enhanced risk measure such as VaR.

This is parametric VaR at 99% confidence level, which assumes normality of the distribution. To remove this assumption that constrains to normality, a modification of the above, Cornish Fisher VaR, can be used. This modified VaR includes the impact of the skewness and kurtosis.


Where (1-α) is the confidence level, z(α) the critical value under normality, S is skewness, and K is excess kurtosis*. The above VaR has been used in the denominator to calculate the enhanced Sharpe Ratio. This enhanced Sharpe ratio has been used as the final risk adjusted performance measure to compare the pure style index against the equity market indexes.


For more details about Skewness and Kurtosis refer Appendix D.


4. PERFORMANCE ANALYSIS 4.1. Raw Returns The figure below compares the growth of US $1 invested in January 1996 in pure style average (PSA) index and that invested in developed markets index (MSCI EAFE), 500 large corporations index (S&P 500) and the small-cap index (Russell 2000) of the US equity market.

Growth of $1 invested in Jan 1996
3.5 3 2.5 2 1.5 1 0.5 0 1995 1996 1996 1997 1997 1998 1998 1999 1999 2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005

Pure Style Average MSCI EAFE S&P 500 Russell 2000

Figure 4.1: Comparison of Cumulative Returns of PSA from 1996 to 2005 with those of MSCI EAFE, S&P 500 and Russell 2000

One can observe that the PSA and the Russell 2000 outperformed the other two (MSCI EAFE and S&P 500) from the beginning. The PSA and Russell 2000 grow on quite similar lines till somewhere in the beginning of 1998, when Russell 2000 loses its momentum leaving the PSA to lead. Major event that had happened during this time and that can be expected to have caused the impact is the collapse of a huge hedge fund – LTCM. Since then the PSA had outperformed the other three. The MSCI EAFE, S&P 500 and the Russell 2000 grow the initial investment of $1 in 1996 to $2.5 in 2005; the PSA grows it to $3.


The figure below compares US $1 invested in January 1996 in the PSA to the traditional, favorite index to many, involving 30 large and frequently traded stocks (DJIA) and a very broad market index, which is often considered to represent the whole of US equity market index.

Growth of $1 Invested in Jan 1996
3.5 3 2.5 2 1.5 1 0.5 0

Pure Style Average DJIA Wilshire 5000
04 04 05 96 97 97 98 98 99 00 00 01 01 02 02 03 20 20 20 19 19 19 19 19 20 20 20 20 20 20 20 20 05


Figure 4.2: Comparison of Cumulative Returns of PSA from 1996 to 2005 with those of DJIA and Wilshire 5000

PSA had initially faced problems in outperforming the market indexes – DJIA and Wilshire 5000. The DJIA and the Wilshire 5000 both outperformed the PSA and appeared to move at a better angle to the PSA. But something happened; sometime during third quarter of 2000 that has changed the scenario. The market indexes fell. A major market event that had happened during this period is the crash of the dot-com bubble, which could have triggered the above consequences. The $1 invested in DJIA and Wilshire 5000 reached a high of $2.35 and $2.24 respectively during 1999-2000 and finally by December 2005 made it to just above $2 whereas the PSA reached the $3 mark.




In the next graph the growth of US $1 invested in PSA is compared to that invested in the mid-cap segment index of the US equity markets.

Growth of $1 invested in Jan 1996
3.5 3 2.5 2 1.5 1 0.5 0
95 96 97 97 98 98 99 00 00 01 01 02 03 02 04 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20

Pure Style Average Russell Midcap
04 05 20 20 20 05

Figure 4.3: Comparison of Cumulative Returns of PSA from 1996 to 2005 with those of Russell Midcap

The story of the growth of the investment remains the same as that discussed above till the first quarter of 2003. But after that, unlike the DJIA and the Wilshire 5000, the Russell Midcap picks up momentum, reaches the PSA and crosses it over to finish with some lead. By the end of 2005, the US $1 invested in the PSA reached the $3 mark whereas that invested in the Russell Midcap reached $3.24. For the reasons of availability of data, the PSA is compared to Russell Microcap by investing US $1 in July 2000. The graph below shows the path of the PSA and that of the micro-cap segment index of the US equity market.


Growth of $1 Invested in July 2000
1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0
03 03 04 04 01 04 02 03 05 05 00 00 01 01 02 02 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 05

Pure Style Average Russell Microcap

Figure 4.4: Comparison of Cumulative Returns of PSA from 2000 to 2005 with those of Russell Microcap

The growth of $1 investment in the PSA was very dull till the beginning of the third quarter of 2003 while the Microcap index most of the time projected negative returns during the same period. Growing from there, by the end of 2003, the Microcap index crosses the PSA and continues to outperform till the end of the period of consideration, December 2005. By the end, the $1 invested in the PSA returns $1.45 while that invested in Russell Microcap index returns $1.66.


4.2. Correlations The table below shows the correlations between the PSA and the market indexes. Index DJIA MSCI EAFE S&P 500 Wilshire 5000 Russell Midcap Russell 2000 Russell Microcap Correlation with PSA 0.57 0.66 -0.03 0.74 0.79 0.82 0.88

Table 4.1: Market Indexes and respective correlation coefficients with PSA

The performance graphs we discussed earlier showed how the markets swung. But the PSA showed very little fluctuations with respect to the market indexes. The same is reflected in the low correlations in the above table with the large cap indexes – DJIA, MSCI EAFE and S&P 500. In fact the PSA is negatively correlated with the S&P 500. This clearly confirms with the researches that indicate the ability of hedge funds to provide diversification benefits to traditional equity investment. In fact this low correlation between hedge funds' performance and the market's ups and downs is the main reason why such funds are valued as alternate investment vehicles. They essentially exploit market inefficiencies, using long or short positions to offset market risks Interesting part of these statistics is the high correlations with the Russell’s small-cap, mid-cap and micro-cap indexes. Researches indicate that the vast majority of equity hedge funds remain focused on the large capitalization end of the market, while the small and micro cap segments, particularly the growth sectors of those segments, have been largely ignored. As of August 2003, less than 2% of the active hedge funds tracked by HedgeFund.net were categorized as small/micro cap funds. Considering this to be the case, the high correlations with the small, mid and micro-cap indexes must indicate that most of the hedge funds though do not fully focus on these segments, their positions definitely have some exposure to these segments and effectively hedged too.


4.3. Volatility Observe the performance graphs above. In all of them, the market indexes wobbled, in fact staggered at a few instances in their path to December 2005. The PSA though, appeared calm and grew its investment quite swiftly. This indicates that the market indexes when compared to the PSA are highly volatile. The following table speaks the same in a different language. Index DJIA MSCI EAFE S&P 500 Wilshire 5000 Russell Midcap Russell 2000 Russell Microcap Pure Style Average (PSA) Annual Standard Deviation 15.82 % 14.85 % 14.92 % 15.87 % 16.27 % 20.17 % 20.83 % 6.53 %

Table 4.2: Indexes and respective annualized standard deviations

The Annual Standard Deviations above talk in real harsh words. Even the Russell Midcap and the Russell Microcap indexes, the only two that outperformed the PSA, have been destroyed when it came to comparing the standard deviation. But the standard deviations in themselves cannot be used as a basis of performance comparison. Standard Deviation relies on the

assumption that the return distribution is symmetric around its mean and implies that the sensitivity of the investor is the same on the upside as on the downside. The problem is that hedge fund returns do not follow the symmetrical return paths implied by traditional volatility. Instead, hedge fund returns tend to be skewed.
Figure 4.5: Graph showing an example of a fat tail (negative skewness)

Specifically, they tend to be negatively skewed, which means they bear the dreaded "fat tails", which are mostly characterized by positive returns but a few cases of extreme losses.


4.4 Sharpe Ratios For the reasons discussed above, to salvage the problem of fat tails, academic studies propose that measures of downside risk can be more useful than volatility or Sharpe ratio as a scale of performance. In order to take the asymmetry in the return distribution into account, the use of downside deviation as risk measure has been frequently advocated (see e.g. Sortino and Price (1994), Bacmann and Pache (2003)). In such a context, the Value-at-Risk, designed to capture the maximum loss over a target time horizon with a given degree of confidence is far better suited. VaR has been getting a very wide acceptance throughout the financial community as it translates a complex risk notion into a simple and synthetic monetary amount. Considering the above reasons and as already discussed earlier in ‘methodology’, modified VaR has been used to calculate an enhanced Sharpe ratio for measuring the performance of the PSA. The table below indicates the enhanced Sharpe ratios of the PSA and the market indexes. Index DJIA MSCI EAFE S&P 500 Wilshire 5000 Russell Midcap Russell 2000 Russell Microcap Pure Style Average (PSA) Enhanced Sharpe Ratio 0.15 0.03 0.22 0.17 0.34 0.18 0.20 0.70

Table 4.3: Indexes and respective Sharpe Ratios, enhanced using VaR

Higher the Sharpe ratio, the better it is. It is common to read that in absolute terms a Sharpe ratio greater than 1 is good. But one cannot judge the performance of an index, which in itself constitutes many funds in absolute terms. Following the same in using the table above, the PSA shows an enhanced Sharpe ratio of 0.70 whereas the market indexes average an enhanced Sharpe ratio of 0.19. This clearly indicates that the PSA, in terms of the enhanced Sharpe ratio, has outperformed the other market indexes by a large margin.


More interesting to observe is how the Russell Midcap stands out of the crowd. But the PSA is still far from it. In the calculation of the Sharpe ratio above, the data made use of starts from January 1996. This means, any decision based on just the ratios above would take into account any event that had happened ten years back too. In other words the Sharpe ratios calculated above do not present us with enough information to understand the current performance of the hedge fund industry. For this reason, the time period of ten years has been divided into four groups – 19961997, 1998-1999, 2000-2002 and 2003-2005. The groups have been formed as to help understand the performance of the PSA with major events in the US stock market during that time. The period of 1996-1997 would represent a period with high interest rates, 1998-1999 would represent how the great disaster of the hedge fund industry – collapse of the Long Term Capital Management – affected the enhanced Sharpe ratio of the PSA, 2000-2002 is the period following burst of the dot-com bubble that changed the opinions of so many bulls, and finally 2003-2005 represents the most recent period. The table below indicates the enhanced Sharpe ratios calculated separately during the four periods of consideration for the PSA and the equity market indexes.

Time Period 1996-1997 1998-1999 2000-2002 2003-2005

DJIA 1.12 0.63 -0.22 0.24

MSCI EAFE -0.09 0.74 -0.54 0.75

S&P 500 1.35 1.56 -0.32 0.50

Wilshire 5000 1.11 1.33 -0.35 0.52

Russell Midcap 0.95 0.43 -0.11 0.95

Russell 2000 0.52 0.21 -0.11 0.64

PSA 2.32 0.58 0.14 1.50

Table 4.4: Enhanced Sharpe Ratios of the Indexes during the four sub-periods

In the high interest rates period (1996-1997), most of the market indexes performed well. MSCI EAFE and the small cap segment index, Russell 2000 are the ones that had


received the beating compared to the rest of the market indexes. But still, the PSA beats the market by a huge margin, projecting an astonishing Sharpe ratio. During the period when one of the biggest hedge funds in America, Long Term Capital Management, collapsed, (1998-1999), the pride of PSA’s outstanding performances got shattered. Except the small and mid-cap segment indexes, the rest four outperformed the PSA when it projects a mild Sharpe ratio of 0.58. The next period: 2000-2002. The bull market run by the dot-coms crashed. All the market indexes projected negative Sharpe ratios. In the midst of the market’s tears though, the PSA stood tall. Though the Sharpe ratio was not absolutely astonishing, the very fact that it projected a positive ratio when the whole market collapsed gained the hedge funds their fame back. The fame that the hedge funds can perform better irrespective of the market direction. The PSA maintains its respect high in the recent period (2003-2005). It continues to beat the market indexes by a considerable margin. Interesting to observe: sudden growth in the Sharpe ratio of the small-cap index. The following graph might help better understand the movement of the enhanced Sharpe ratio of the indexes with time.


4.5. Correlations with Time The following table indicates how the correlation between the PSA and the market indexes changed during the four periods considered. Time Period 1996-1997 1998-1999 2000-2002 2003-2005 DJIA 0.66 0.73 0.37 0.68 MSCI EAFE 0.55 0.68 0.68 0.83 S&P 500 0.75 0.75 0.55 0.76 Wilshire 5000 0.82 0.81 0.64 0.79 Russell Midcap 0.83 0.81 0.77 0.83 Russell 2000 0.74 0.86 0.86 0.80

Table 4.5: Correlations of the Market Indexes with the PSA during the four sub-periods

One can observe that the correlation between the PSA and the small and mid-cap segment indexes have been consistently high. It was highly correlated with the Russell indexes when the market on the whole had destroyed the PSA (1998-1999) and it was highly correlated even when the PSA gains back its fame (2000-2002). The correlation of the PSA with the MSCI EAFE, which represents developed markets other than, US had been slowly increasing during 1996-2002 and had suddenly jumped to high levels in the most recent period (2003-2005). This might indicate that the hedge funds realized that the US markets have saturated and exploiting inefficiencies in valuation has become difficult and thus moved to the other developed markets to gulp the new potential.


5. THE DECLINE Although the PSA shows that the hedge fund industry as such is being successful in outperforming the market indexes, one must also accept that the average returns generating ability of a hedge fund has gone down with the growth in the number of hedge funds. There is a feeding frenzy currently under way in the world of alternative investments and clients are paying up the higher fees for fear of being locked out from these funds at a later date, if they actually survive and grow. One reason why the new boys are focusing more on fees and lock-ups could be the difficulty all hedge funds are having in generating adequate alpha (excess return) to ensure an adequate payout. In a study done by Morgan Stanley on the excess returns generated by hedge funds over the last decade, this trend of declining returns was very apparent. In the study they defined excess returns as the return of the Hedge Fund research composite over one month LIBOR (a proxy for cash returns). In the 1995-97 period, excess returns were 14 per cent; and as the research indicates, these returns have consistently declined dropping to as low as 5 per cent in 2001-03 and have dropped further since. The beauty of the hedge fund business and the reason why the upward drift in fee structure is even more surprising is the ease of entry of new players into the game. The average long short hedge fund needs only about six back office staff per billion dollars, while a global macro fund needs about 11 people for a fund of similar size (Morgan Stanley survey). The typical long short US equity manager has only nine investment professionals and three in the back office. These funds are also not really regulated and have very limited disclosure requirements, if any. The start-up costs of these vehicles are also minimal and most funds will be able to break even at sub $100 million in assets under management. Hedge funds are clearly here to stay, and continue to attract the best talent because of their payout structures; however, their ability to continue to command a premium fee


structure will eventually be limited by their ability to differentiate themselves from their long-only counterparts. Researches (Fung, Hsieh, Naik, and Ramadorai, 2005) also indicate that there is an apparent mismatch between the supply and demand for alpha. On the one hand, the supply of alpha appears to be drying up. On the other, capital appears to be seeking alpha. This could presage changes in the organization of the hedge fund industry. Contracts in the hedge fund industry are currently structured to reward managers for generating returns above pre-specified fixed benchmarks. Conditioning incentives on risk-adjusted performance may be a better way to go. In other words, a fund manager must be provided with his incentive fees, which instead of basing on total returns must be based on the generated alpha (excess returns). If such a scenario develops in the hedge fund industry, the new players entering the industry would be more careful in applying sophisticated strategies, generating better returns.


6. CONCLUSIONS Hedge funds have attracted significant capital over the last decade triggered by successful track records. The number of hedge funds has also increased rapidly from 100 to about 7000 between 1987 and 2004. The capital inflows into the industry have got the extra push with institutions like pension funds and endowments showing interest in hedge funds. Most of the growth in the hedge funds is concentrated in just US market. In recent times, though, the acceptance of hedge funds seems to be growing through out other markets – Europe and Asia with Japan growing as the new potentially big center. The previously enjoyed by the high net worth individuals, hedge funds, are making their way to other segments of the market too - institutional and retail investors. Funds of funds (hedge funds) and other hedge fund-linked products are increasingly being marketed to the retail investors in some jurisdictions. Public funds, endowments, and corporate sponsors have all increased their allocations to hedge funds within the context of an increased allocation towards alternative investments more generally, in expectation of higher returns. The cumulative return performance of the Pure Style Hedge Fund Index calculated through simple average using a returns data of 10 years (1996-2005) shows the hedge fund industry to grow its investment at better rates than most of the market indexes. In the more recent times, the Russell’s Midcap and Microcap indexes outperformed the Pure Style Index. In terms of Standard Deviation, the PSA had made itself a place at a high elevation, far from the market indexes. The performance graphs indicate that the volatility of the hedge funds on an average are quite low compared to the market indexes and thus can be considered to as ‘living up to their name – Hedge Funds”.


The enhanced Sharpe ratio calculated using the Cornish-Fisher VaR indicates superior performance by the Pure Style Average and thus the hedge fund industry on an average. The PSA outperforms the market indexes in the overall period of consideration (10 years) and also thrice in four sub-divided periods. Correlation between the PSA and the small and mid-cap segment indexes has been consistently high during the sub-divided periods. The slow and sudden rises of the correlation between the pure style index and the MSCI EAFE indicates that the hedge funds realized that the US markets have saturated and exploiting inefficiencies in valuation has become difficult and thus moved to the other developed markets to gulp the new potential. Though the pure style index outperforms the market by a big margin, the absolute returns of the hedge funds have got diluted with the increase in the number of new players. One solution to this could be charging incentive fees based on alphas instead of the total absolute returns. Also the alphas have to be measured with respect to a benchmark that assumes similar risk profile.


REFERENCES Jeffrey P. James, ‘Exploiting the Inefficiencies of The Small Cap Market Through Hedge Funds’, AIMA Journal, December 2003. GFS Induction Programme, ‘Hedge Fund Strategies’, M Allen, Aug 2004. Martin Eling, ‘Autocorrelation, Bias and Fat Tails – Are Hedge Funds Really Attractive Investements? ’, Working Papers on Risk Management and Insurance No. 8, Universitat St. Gallen. Alexander M. Ineichen, ‘Hedge Funds: Bubble or New Paradigm? ‘, Journal of Global Financial Markets, Vol.2, No. 4, 21 November 2001. The President’s Working Group on Financial Markets, ‘Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management’, April 1999. William Reichenstein, ‘What Are You Really Getting When You Invest in a Hedge Fund?‘, July 2004. LJH Global Investments, ‘Why Invest in Hedge Funds Anyway? ‘, June 2001. Investor Force, ‘Hedge Fund Survey’, January 2003. Harry M Kat, Sa Lu, ‘An Excursion into the Statistical Properties of Hedge Funds’, ISMA Discussion Papers in Finance 2002-12, 1 May 2002. Francis Koh, Winston T. H. Koh, and Melvyn Teo, ‘Asian Hedge Funds: Return Persistence, Style, and Fund Characteristics’, June 2003. Standard & Poor’s, ‘December Rally Adds to Hedge Fund Returns for 2005’, 11 January 2006. Jean Francois Bacmann and Gregor Gawron, ‘Fat Tail Risk in Portfolios of Hedge Funds and Traditional Investements’, RMF Investment Group, January 2004. Mark Chambers, ‘Hedge Fund Indices’, Man Investment Products, AIMA Journal, December 2002. Thomas Della Casa and Mark Rechsteiner, ‘Hedge Fund Indices’, RMF Hedge Fund Research, December 2004. Walter Gehin, ‘Hedge Fund Returns: An Overview of Return-Based and Asset-Based Style Factors’, January 2006.


Roger W. Merritt, Fitch Ratings, and Ian C. Linnell, ‘Hedge Funds: An Emerging Force in the Global Credit Markets’, 28 February 2006. David Setters, ‘Hedge Funds and Derivatives: A Maturing Relationship’. Francois-Serge Lhabitant, ‘Hedge Funds Investing: A Quantitative Look Inside the Black Box’, August 2001. Staff Report to the United States Securities and Exchange Commission, ‘Implications of Growth of Hedge Funds’, September 2003. Eurekahedge, ‘Key Trends in Asian Hedge Funds’, AIMA Journal, April 2004. Beng Liang, ‘On the Performance of Hedge Funds’, May 1998. Hedgequest, ‘Searching for the perfect risk-adjusted performance measure’, Summer 2005. Noel Amanc and Lionel Martellini, ‘The Brave New World of Hedge Fund Indexes’, 28 January 2002. Vadim Zlotnikov and Guillermo Maclean, ‘Hedge Fund Industry Update – One Year Later, The Song Remains the Same’, Bernstein Research Call, 28 July 2004. David Gordon, ‘What Goes Up, Comes Down’, 2002 AIC Conference. Harry M. Kat, ’10 Things That Investors Should Know About Hedge Funds’, Spring 2003. CISDM Research Department, ‘Benefits of Hedge Funds’, 2005 Update. Capocci Daniel, ‘An Analysis of Hedge Fund Performance 1984-2000’, November 2001. Capocci Daniel, ‘Comparitive Analysis of Hedge Fund Returns’, January 2006. William Fung, David A. Hsieh, Narayan Y. Naik and Tarun Ramadorai, ‘Hedge Funds: Performance, Risk and Capital Formation’, September 2005. Kevin Dowd, ‘Too Big To Fail? Long Term Capital Management and the Federal Reserve’, 23 September 1999. Jenny Corbett and David Vines, ‘East Asian Currency and Financial Crises: Lessons from Vulnerability, Crisis and Collapse’, Asia Pacific Press, 1999. Lindsay I Smith, ‘A Tutorial on Principal Components Analysis’, 26 February 2002.


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APPENDIX A: ABCs of Hedge Funds

What is a Hedge Fund? A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously -- many hedge against downturns in the markets -- especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions. Key Characteristics of Hedge Funds Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage. Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment


business. In addition, hedge fund managers usually have their own money invested in their fund. Facts About the Hedge Fund Industry Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives. Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept. Hedge fund managers are generally highly professional, disciplined and diligent. Beyond the averages, there are some truly outstanding performers. Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, that have lived through, and understand the consequences of, major stock market corrections. An increasing number of endowments and pension funds allocate assets to hedge funds. Hedging Strategies A wide range of hedging strategies are available to hedge funds. For example: Selling short - selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop. Using arbitrage - seeking to exploit pricing inefficiencies between related securities - for example, can be long convertible bonds and short the underlying issuers equity. Trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment.


Investing in anticipation of a specific event - merger transaction, hostile takeover, spin-off, exiting of bankruptcy proceedings, etc. Investing in deeply discounted securities - of companies about to enter or exit financial distress or bankruptcy, often below liquidation value. Hedge Fund Styles The predictability of future results shows a strong correlation with the volatility of each strategy. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility. Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Tends to be "long-biased." Expected Volatility: High Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market's lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets. Expected Volatility: Low – Moderate Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available, although Brady debt can be partially hedged via U.S. Treasury futures and currency markets. Expected Volatility: Very High


Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low - Moderate – High Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Expected Volatility: Low Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but the leveraged directional investments tend to make the largest impact on performance. Expected Volatility: Very High Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low


Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. Usually low or no correlation with the market. Sometimes uses market index futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills. Expected Volatility: Low Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. Expected Volatility: High Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. Expected Volatility: Variable Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable Short Selling: Sells securities short in anticipation of being able to re-buy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to


accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. May also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. Results generally not dependent on direction of market. Expected Volatility: Moderate Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Analysts may out of favor or under follow such securities. Long-term holding, patience, and strong discipline are often required until the market recognizes the ultimate value. Expected Volatility: Low – Moderate

Popular Misconception The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage.


Benefits of Hedge Funds Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns. Huge variety of hedge fund investment styles – many uncorrelated with each other – provides investors with a wide choice of hedge fund strategies to meet their investment objectives. Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets. Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing.

How does a hedge fund "hedge" against risk? Some funds that are called hedge funds don't actually hedge against risk. Because the term is applied to a wide range of alternative funds, it also encompasses funds that may use high-risk strategies without hedging against risk of loss. For example, a global macro strategy may speculate on changes in countries' economic policies that impact interest rates, which impact all financial instruments, while using lots of leverage. The returns can be high, but so can the losses, as the leveraged directional investments (which are not hedged) tend to make the largest impact on performance. Most hedge funds, however, do seek to hedge against risk in one way or another, making consistency and stability of return, rather than magnitude, their key priority. (In fact, less than 5 percent of hedge funds are global macro funds). Event-driven strategies, for example, such as investing in distressed or special situations reduce risk by being uncorrelated to the markets. They may buy interest-paying bonds or trade claims of companies undergoing reorganization,


bankruptcy, or some other corporate restructuring - counting on events specific to a company, rather than more random macro trends, to affect their investment. Thus, they are generally able to deliver consistent returns with lower risk of loss. Long/short equity funds, while dependent on the direction of markets, hedge out some of this market risk through short positions that provide profits in a market downturn to offset losses made by the long positions. Market neutral equity funds, which invest equally in long and short equity portfolios generally in the same sectors of the market, are not correlated to market movements. A true hedge fund then is an investment vehicle whose key priority is to minimize investment risk in an attempt to deliver profits under all circumstances.


What is the difference between a hedge fund and a mutual fund? There are five key distinctions: 1. Mutual funds are measured on relative performance - that is, their performance is compared to a relevant index such as the S&P 500 Index or to other mutual funds in their sector. Hedge funds are expected to deliver absolute returns - they attempt to make profits under all circumstances, even when the relative indices are down. 2. Mutual funds are highly regulated, restricting the use of short selling and derivatives. These regulations serve as handcuffs, making it more difficult to outperform the market or to protect the assets of the fund in a downturn. Hedge funds, on the other hand, are unregulated and therefore unrestricted - they allow for short selling and other strategies designed to accelerate performance or reduce volatility. However, an informal restriction is generally imposed on all hedge fund managers by professional investors who understand the different strategies and typically invest in a particular fund because of the manager's expertise in a particular investment strategy. These investors require and expect the hedge fund to stay within its area of specialization and competence. Hence, one of the defining characteristics of hedge funds is that they tend to be specialized, operating within a given niche, specialty or industry that requires a particular expertise. 3. Mutual funds generally remunerate management based on a percent of assets under management. Hedge funds always remunerate managers with performancerelated incentive fees as well as a fixed fee. Investing for absolute returns is more demanding than simply seeking relative returns and requires greater skill, knowledge, and talent. Not surprisingly, the incentive-based performance fees tend to attract the most talented investment managers to the hedge fund industry. 4. Mutual funds are not able to effectively protect portfolios against declining markets other than by going into cash or by shorting a limited amount of stock index futures. Hedge funds, on the other hand, are often able to protect against


declining markets by utilizing various hedging strategies. The strategies used, of course, vary tremendously depending on the investment style and type of hedge fund. But as a result of these hedging strategies, certain types of hedge funds are able to generate positive returns even in declining markets. 5. The future performance of mutual funds is dependent on the direction of the equity markets. It can be compared to putting a cork on the surface of the ocean the cork will go up and down with the waves. The future performance of many hedge fund strategies tends to be highly predictable and not dependent on the direction of the equity markets. It can be compared to a submarine traveling in an almost straight line below the surface, not impacted by the effect of the waves.


What is a Fund of Hedge Funds? A diversified portfolio of generally uncorrelated hedge funds. May be widely diversified, or sector or geographically focused. Seeks to deliver more consistent returns than stock portfolios, mutual funds, unit trusts or individual hedge funds. Preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals. Provides access to a broad range of investment styles, strategies and hedge fund managers for one easy-to-administer investment. Provides more predictable returns than traditional investment funds. Provides effective diversification for investment portfolios. Benefits of a Hedge Fund of Funds Provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. Delivers more stable returns under most market conditions due to the fund-offund manager’s ability and understanding of the various hedge strategies. Significantly reduces individual fund and manager risk. Eliminates the need for time-consuming due diligence otherwise required for making hedge fund investment decisions. Allows for easier administration of widely diversified investments across a large variety of hedge funds. Allows access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements. Is an ideal way to gain access to a wide variety of hedge fund strategies, managed by many of the world’s premier investment professionals, for a relatively modest investment.


APPENDIX B: About Hedge Fund Indexes ALTVEST InvestorForce produces a family of 14 hedge fund indices, the master index (Altvest hedge fund index) and 13 sub-indices. The indices are equal weighted for all included hedge funds that have complete performance records since trading commencement. The master index and sub-indices commence January 1993. The number of funds included in the indices will continue to grow as new funds meet the specified criteria. In the following, the "current performance month" corresponds to previous calendar month (for example, if March 2000 is the current performance month, April 2000 is the current calendar month). Current performance month index returns will be updated everyday of the current calendar month as InvestorForce funds report and new funds are added on InvestorForce. InvestorForce will freeze the current performance month return at 2300 hours on the last day of the current calendar month. Monthly historical numbers will never be rebalanced to account for new funds added or funds removed. Calculation Methodology For each month the universe of funds that meet the specified criteria are grouped according to master and as well as sub-index. For each grouping an arithmetic average is calculated for the given month.

Simple average of monthly rates of return:

Where Ri = rate of return (net of all fees) for the ith month since inception, and s = # of months since inception


Master Index: The master index is comprised of all funds on the InvestorForce database that have reported performance for the current month and provided complete performance records since the time of trading commencement. All sub indices are comprised of funds that are included in the master index.


CSFB / TREMONT Index Characteristics The Credit Suisse/Tremont Hedge Fund Index is the largest asset-weighted hedge fund index. Unlike even-weighted indices, it does not underweight top performers and overweight decliners. The Credit Suisse/Tremont Hedge Fund Index is broadly diversified, encompassing 424 funds (April 2006) across ten style-based sectors, and representative of the entire hedge fund industry. Index construction is fully transparent, with unbiased, rules - based selection criteria and published constituents. Rigorous reporting standards are required of member funds, including monthly performance disclosure and audited financial statements. Credit Suisse / Tremont Hedge Fund Index Specifications The industry’s first asset-weighted hedge fund index. Provides investors with the first suite of indices designed from the ground up to provide meaningful performance measurement—not built around an investable product. Composite Index comprised of ten style-based sector indices Funds drawn from the Credit Suisse/Tremont database of approximately 4500 funds Selection universe consists of funds meeting Credit Suisse/Tremont minimum criteria: Timely and accurate NAV reporting—every month Audited financial statements At least $50 million under management One-year track record (discretionary exceptions for funds


With more than $500 million under management) Index represents at least 85% of assets under management in selection universe for each sector—total composite Index membership of 424 funds (April 2006).


EACM-100 ONSHORE The EACM100® Index is an equally-weighted composite of 100 hedge funds selected by EACM Advisors LLC (EACM) to be a representative sample of the various hedge fund strategies available to investors. EACM100® is designed to be an intelligent benchmark, with manager participation based on both quantitative and qualitative factors. The EACM100® Index is not a database. It is an investable group of 100 investment managers, chosen by the investment professionals at EACM to effectively sample the universe of hedge fund styles. Managers are grouped into 5 broad investment strategies, which are further cut into 12 sub-strategies. Performance results are calculated at each level to provide a better understanding of strategy and sub-strategy performance. The Index is useful as a diversified composite of hedge fund styles or as selected strategies and/or sub-strategies. The EACM100® Index is designed to mimic a reasonably constructed fund of hedge funds product. Specific strategy weights are set by EACM, using an investment-driven approach. Individual managers are always equally weighted at the beginning of each calendar year, with each manager representing 1% of the total index. This approach provides a useful framework for analysis and avoids the pitfalls of a haphazard grouping of managers whose strategy weights are solely determined by availability of data. Manager Selection Performance is not the key factor to manager selection. The investment professionals at EACM carefully review the investment discipline of each manager and select only funds, which are representative of a specific trading style. Inclusion in the Index is not contingent on any prior business arrangement with EACM, nor do investment managers


pay any fees to participate. However, managers do agree to a number of terms and conditions. Each manager must have at least a two-year live performance record, a minimum of $20 million in the investment strategy, be open for new investments, and provide at least annual liquidity. Only managers with both an onshore and offshore version of the same product can be considered. Managers also agree to provide monthly performance results on a timely basis, including any and all revisions, and to provide fund documentation, such as offering memoranda and audited financials. Performance is also not a cause for removal from the EACM100®. Funds are dropped from the Index for a variety of reasons, but poor performance will result in removal only where a blow-up situation occurs and the fund dissolves. During a blow-up situation, the complete results of the ailing fund are reflected in the Index totals. More common reasons for manager replacements include straying from the investment strategy, a lack of adequate assets under management, not being open to new investments or simply closing-up shop. The manager line-up is reviewed on an annual basis and substitutions are made at the beginning of each calendar year. In the case of managers dropping out during the year, a special rebalancing is performed at mid-year. Manager selection or removal is not a capricious act; it is a well thought out decision, made only after careful review.



Methodology The HFRI Monthly Indices (HFRI) are equally weighted performance indexes, utilized by numerous hedge fund managers as a benchmark for their own hedge funds. The HFRI are broken down into 37 different categories by strategy, including the HFRI Fund Weighted Composite, which accounts for over 1600 funds listed on the internal HFR Database. Due to mutual agreements with the hedge fund managers listed in the HFR Database, we are not at liberty to disclose the particular funds behind any index to nondatabase subscribers.

Funds included in the HFRI Monthly Indices must:
• • •

Report monthly returns Report Net of All Fees Returns Report assets in USD

Indices Notes:
• • •

All HFRI Indices are fund weighted (equal weighted). There is no required asset-size minimum for fund inclusion in the HFRI. There is no required length of time a fund must be actively trading before inclusion in the HFRI. The HFRI are updated three times a month: Flash Update (5th business day of the month), Mid Update (15th of the month), and End Update (1st business day of following month)

The current month and the prior three months are left as estimates and are subject to change. All performance prior to that is locked and is no longer subject to change. 49

If a fund liquidates/closes, that fund's performance will be included in the HFRI as of that fund's last reported performance update. The HFRI Fund of Funds Index is not included in the HFRI Fund Weighted Composite Index. Both domestic and offshore funds are included in the HFRI. In cases where a manager lists mirrored-performance funds, only the fund with the larger asset size is included in the HFRI.

• •


HENNESSEE HEDGE FUND INDEX The Hennessee Hedge Fund Indices® are calculated from performance data supplied by a diversified group of hedge funds monitored by the Hennessee Group LLC. The Hennessee Hedge Fund Index® is believed to represent over half of the capital in the industry and is an equally-weighted average of the funds in the Hennessee Hedge Fund Indices®. The funds in the Hennessee Hedge Fund Index® are believed to be statistically representative of the larger Hennessee Universe of over 3,000 hedge funds and are net of fees and unaudited. Past performance is no guarantee of future returns.

Conditions for inclusion in the index are as follows:
• •

The firm should have at least $10 million in hedge fund assets. The fund should have at least 12 months of track record. An exception will be extended to any firm, which has over $100 million in hedge fund assets. The fund should satisfy the Hennessee Group LLC reporting requirements. Funds are not eliminated from the index unless they are liquidated or fail to satisfy the inclusion criteria, as set forth above. If eliminated, the fund's past performance will remain in the index in order to avoid survivorship bias.

• •

Rebalancing of the index will take place on an annual basis.



The MSCI Hedge Invest Index is designed to be both investable and to reflect the overall structure and composition of the hedge fund universe. The MSCI Hedge Invest Index aims to reflect the overall structure and composition of the hedge fund universe from the funds available on a hedge fund platform managed by Lyxor Asset Management. The funds on the platform available for the index offer weekly liquidity. To replicate the characteristics of the overall hedge fund universe, MSCI starts with the MSCI Hedge Fund Composite Index, constructed independently of any hedge fund platform, and identifies the most liquid and significant investment segments. The investable index is rebalanced quarterly and the indicative index performance is published daily on www.msci.com and Bloomberg. At the October 2005 Quarterly Index Review, the number of funds in the MSCI Hedge Invest Index increased to 125, with the investment segment weights set forth below. Note that the number of funds included in the index is expected to grow as the platform expands.


VAN GLOBAL HEDGE FUND INDEX About VAN Founded in 1992, Van was the first to collect data and perform large-scale research on the broad universe of hedge funds. Today, Van is recognized as an alternative investment expert with one of the most comprehensive hedge fund platforms available and is the provider of the Van Global Hedge Fund Index, an industry-standard benchmark of the hedge fund asset class. In addition to the index publishing and research division, Van is a leading hedge fund investment advisor and provider of index-linked hedge fund products and services to investors worldwide. Several of the Van Companies are registered as Investment Advisors with the SEC. Van has one of the oldest and most extensive hedge fund management platforms in existence, tracking more than 6,700 funds worldwide. This number includes only hedge funds as they are generally defined, and excludes fund-of-funds as well as certain other types of investments such as private equity funds, venture capital funds, separately managed account strategy composites, etc. Both quantitative and qualitative information is included for each fund in the database. Institutional investors, hedge fund managers and media worldwide recognize Van as an authoritative source for hedge fund indexing. Van’s flagship indices, the Van Global Hedge Fund Indices, are considered among the financial industry’s oldest and most widely utilized composite benchmarks of global hedge fund performance. Initially compiled in 1994 and published in 1995, the Van Global Hedge Fund Indices provide more than 17 years of aggregate risk and return history that represent the average performance of hedge funds around the world, tracking the performance of the overall hedge fund universe. The indices and strategy sub-indices, updated monthly, are based on underlying hedge funds returns, are net of underlying manager fees, and are simple averages (not dollar-weighted averages) and do not include Fund-of-funds.


A minimum of 100 funds is required for the preliminary index, a minimum of 800 funds is required for the mid-month index, and a minimum of 1,000 funds is required for the month-end index. The actual number of constituents for these indices often greatly exceeds the minimum requirements, especially for the preliminary and month-end indices.


APPENDIX C: About Market Indexes

DOW JONES INDUSTRIAL AVERAGE Overview When Charles H.Dow first unveiled his industrial stock average on May 26, 1896, the stock market was not highly regarded. Prudent investors bought bonds, which paid predictable amounts of interest and were backed by real machinery, factory buildings and other hard assets. Today, stocks are routinely considered as investment vehicles, even by conservative investors. The circle of investors has widened far beyond the Wall Street cliques of the past century to millions of everyday working men and women. These people are turning to stocks to help them amass capital for their children's college tuition bills and their own retirements. Information to guide them in their investment decisions is abundantly available. The Dow Jones Industrial Average played a role in bringing about this tremendous change. One hundred years ago, even people on Wall Street found it difficult to discern from the daily jumble of up-a-quarter and down-an-eighth whether stocks generally were rising, falling or treading water. Charles Dow devised his stock average to make sense out of this confusion. He began in 1884 with 11 stocks, most of them railroads, which were the first great national corporations. He compared his average to placing sticks in the beach sand to determine, wave after successive wave, whether the tide was coming in or going out. If the average's peaks and troughs rose progressively higher,then a bull market prevailed; if the peaks and troughs dropped lower and lower, a bear market was on. It seems simplistic nowadays with myriad market indicators, but late in the Nineteenth Century it was like turning on a powerful new beacon that cut through the fog. The average provided a convenient benchmark for comparing individual stocks to the course of the market, for comparing the market with other indicators of economic conditions, or


simply for conversation at the corner of Wall and Broad Streets about the market's direction. The mechanics of the first stock averages were dictated by the necessity of computing it with paper and pencil: Add up the prices and divide by the number of stocks. This application of grade-school arithmetic, while creative is hardly worthy of remembrance more than a century later. But the very idea of using an index to differentiate the stock market's long-term trends from short-term fluctuations deserves a salute. Without the means for the ordinary investor to follow the broad market, today's age of financial democracy (in which millions of employees are actively directing the investment of their own future pension money and as a result are substantial corporate shareholders) would be unimaginable. Following the introduction of the 12-stock industrial average in the spring of 1896, Mr. Dow, in the autumn of that year, dropped the last non-railroad stocks in his original index, making it the 20-stock railroad average. The utility average came along in 1929 (more than a quarter-century after Mr.Dow's death at age 51 in 1902) and the railroad average was renamed the transportation average in 1970. At first, the average was published irregularly, but daily publication in The Wall Street Journal began on Oct. 7, 1896. In 1916, the industrial average expanded to 20 stocks; the number was raised again, in 1928, to 30, where it remains. Also in 1928, the Journal editors began calculating the average with a special divisor other than the number of stocks, to avoid distortions when constituent companies split their shares or when one stock was substituted for another. Through habit, this index was still identified as an "average." The 30 stocks now in the Dow Jones Industrial Average are all major factors in their industries, and their stocks are widely held by individuals and institutional investors. The DJIA accounts for approximately 23.8% of the total U.S. market, as measured by the Dow Jones Wilshire 5000 Index, as of December 13,2005.


Using such large, frequently traded stocks provides an important feature of the Industrial Average: timeliness. At any moment during the trading day, the Dow Jones Industrial Average is based on very recent transactions. This isn't always true with indexes that contain less-frequently traded stocks. The Dow Jones Industrial Average is the most-quoted market indicator in newspapers, on TV and on the Internet. Because of its longevity, it became the first to be quoted by other publications. This practice became habit when Wall Street earned at least a mention in the general news each day, and habit became tradition when the post-World War II bull market galvanized the nation's attention. The Industrial Average became the indicator to cite if you were citing only one. Besides longevity, two other factors play a role in its widespread popularity: It is understandable to most people, and it reliably indicates the market's basic trend.


MSCI EAFE INDEX MSCI has been the world’s leading benchmark provider since 1969, providing global, regional and sector products and services to international investors. In North America, MSCI’s market share of the international equity indexing industry is over 90%. MSCI has achieved this preeminent position by constructing precise benchmarks that consistently reflect the business activities of equity markets worldwide. MSCI’s Equity Indices are developed and maintained by an experienced staff of researchers based in Europe, the United States and Asia. The MSCI EAFE Index® is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indices, representing the developed markes outside of North America: Europe, Australasia and the Far East. Since inception in, the MSCI EAFE Index has had an average gross annual return of 11.2%. MSCI aims to include in its international indices 85% of the free fl oat-adjusted market capitalization in each industry group, within each country. As of Dec 30, 2005 the MSCI EAFE Index contained 1,137 securities with a total market capitalization of over USD 10.2 trillion.


S&P 500 The S&P 500 is a list of 500 US corporations, ordered by market capitalization. All of the companies in the list are large publicly-held companies which trade on major US stock exchanges such as the New York Stock Exchange and Nasdaq. The market-value weighted performance of the stocks of these companies is known as the S&P 500 index. After the Dow Jones Industrial Average, the S&P 500 is the most widely-watched index of large-cap US stocks and is considered to be a bellwether for the US economy. Many index funds and exchange-traded funds track the performance of the S&P 500 by holding the same stocks as the S&P 500 index, attempting to match its performance. Partly because of this, a company which has its stock added to the list may see a boost in its stock price as mutual fund managers are forced to purchase that company's stock in order to match their index funds' composition to that of the S&P 500 index. Although the 500 companies in the list are among the largest in the US, it is not simply a list of the 500 biggest companies. The companies are carefully selected to ensure that they are representative of various industries in the US economy. In addition, companies which are privately held and stocks which do not have sufficient liquidity are not in the index. The index was previously market-value weighted; that is, movements in price of companies whose total market valuation (share price times the number of outstanding shares) is larger will have a greater effect on the index than companies whose market valuation is smaller. The index has since been converted to float weighted; that is, only shares available for public trading ("float") are counted. The transition was made in two tranches, the first on March 18, 2005 and the second on September 16, 2005.


WILSHIRE 5000 The Dow Jones Wilshire 5000 Total Stock Market Index, also known as the Dow Jones Wilshire 5000 Composite Index or simply the Wilshire 5000 is a broad base stock market index often used to represent the entire United States stock market. It measures the performance of all public companies based in the United States with "readily available price data"; that is, the value of common stock, real estate investment trusts (REITs), and limited partnerships of companies whose primary stock market listing is on the New York Stock Exchange, NASDAQ, or American Stock Exchange. The Wilshire 5000 is a market capitalization-weighted index, meaning price change in its components are factored against the total market capitalization of those components. Dow Jones publishes both an index based on full market capitalization and also one based on a float-adjusted market capitalization, reflecting the number of shares actually available to trade. The list of securities is updated monthly to add new listings for corporate spin-offs and initial public offerings, and to remove companies which move to the pink sheets or stop trading for ten days. The index was created by Wilshire Associates in 1974 and named for the approximate number of issues it included at that time. It was renamed the "Dow Jones Wilshire 5000" after the Dow Jones & Company took over responsibility for its calculation and maintenance in April 2004.


RUSSELL MIDCAP The Russell Midcap Index offers investors access to the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is constructed to provide a comprehensive and unbiased barometer for the mid-cap segment and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true midcap opportunity set. The Russell Midcap Index includes the smallest 800 securities in the Russell 1000. RUSSELL 2000 The Russell 2000 Index offers investors access to the small-cap segment of the U.S. equity universe. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. The Russell 2000 includes the smallest 2000 securities in the Russell 3000. RUSSELL MICROCAP The Russell Microcap Index offers investors access to the Microcap segment of the U.S. equity market. It makes up less than 3% of the U.S. equity market and is represented by the smallest 1,000 securities in the small-cap Russell 2000 Index plus the next 1,000 securities. Russell Microcap Index is constructed to provide a comprehensive and unbiased barometer for the Microcap segment trading on national exchanges, while excluding lesser-regulated OTC bulletin board securities and pink-sheet stocks due to their failure to meet national exchange listing requirements. The Russell Microcap Index is completely reconstituted annually to ensure larger stocks do not distort performance and characteristics of the true Microcap opportunity set.


APPENDIX D: About Skewness and Kurtosis

A fundamental task in many statistical analyses is to characterize the location and variability of a data set. A further characterization of the data includes skewness and kurtosis. Skewness is a measure of symmetry, or more precisely, the lack of symmetry. A distribution, or data set, is symmetric if it looks the same to the left and right of the center point. Kurtosis is a measure of whether the data are peaked or flat relative to a normal distribution. That is, data sets with high kurtosis tend to have a distinct peak near the mean, decline rather rapidly, and have heavy tails. Data sets with low kurtosis tend to have a flat top near the mean rather than a sharp peak. A uniform distribution would be the extreme case.

The histogram is an effective graphical technique for showing both the skewness and kurtosis of data set.

For univariate data Y1, Y2, ..., YN, the formula for skewness is:


is the mean, s is the standard deviation, and N is the number of data points. The

skewness for a normal distribution is zero, and any symmetric data should have skewness near to zero. Negative values for the skewness indicate data that are skewed left and positive values for the skewness indicate data that are skewed right. By skewed left, we mean that the left tail is long relative to the right tail. Similarly, skewed right means that


the right tail is long relative to the left tail. Some measurements have a lower bound and are skewed right. For example, in reliability studies, failure times cannot be negative. For univariate data Y1, Y2, ..., YN, the formula for kurtosis is:


is the mean, s is the standard deviation, and N is the number of data points.

The kurtosis for a standard normal distribution is three. For this reason, excess kurtosis is defined as

so that the standard normal distribution has a kurtosis of zero. Positive kurtosis indicates a "peaked" distribution and negative kurtosis indicates a "flat" distribution. The following example shows histograms for 10,000 random numbers generated from a normal, a double exponential, a Cauchy, and a Weibull distribution.


The first histogram is a sample from a normal distribution. The normal distribution is a symmetric distribution with well-behaved tails. This is indicated by the skewness of 0.03. The kurtosis of 2.96 is near the expected value of 3. The histogram verifies the symmetry. The second histogram is a sample from a double exponential distribution. The double exponential is a symmetric distribution. Compared to the normal, it has a stronger peak, more rapid decay, and heavier tails. That is, we would expect a skewness near zero and a kurtosis higher than 3. The skewness is 0.06 and the kurtosis is 5.9. The third histogram is a sample from a Cauchy distribution. For better visual comparison with the other data sets, we restricted the histogram of the Cauchy distribution to values between -10 and 10. The full data set for the Cauchy data in fact has a minimum of approximately -29,000 and a maximum of approximately 89,000. The Cauchy distribution is a symmetric distribution with heavy tails and a single peak at the center of the distribution. Since it is symmetric, we would expect skewness to be near zero. Due to the heavier tails, we might expect the kurtosis to be larger than for a normal distribution. In fact the skewness is 69.99 and the kurtosis is 6,693. These extremely high values can be explained by the heavy tails. Just as the mean and standard deviation can be distorted by extreme values in the tails, so too can the skewness and kurtosis measures. The fourth histogram is a sample from a Weibull distribution with shape parameter 1.5. The Weibull distribution is a skewed distribution with the amount of skewness depending on the value of the shape parameter. The degree of decay as we move away from the center also depends on the value of the shape parameter. For this data set, the skewness is 1.08 and the kurtosis is 4.46, which indicates moderate skewness and kurtosis. Many classical statistical tests and intervals depend on normality assumptions. Significant skewness and kurtosis clearly indicate that data are not normal. If a data set exhibits significant skewness or kurtosis (as indicated by a histogram or the numerical measures), what can we do about it?


One approach is to apply some type of transformation to try to make the data normal, or more nearly normal. The Box-Cox transformation is a useful technique for trying to normalize a data set. In particular, taking the log or square root of a data set is often useful for data that exhibit moderate right skewness. Another approach is to use techniques based on distributions other than the normal. For example, in reliability studies, the exponential, Weibull, and lognormal distributions are typically used as a basis for modeling rather than using the normal distribution. The probability plot correlation coefficient plot and the probability plot are useful tools for determining a good distributional model for the data.


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