Democratization of Hedge Funds Redefining Alpha and Beta in Hedge Fund Returns

1. Democratization of Hedge FundsRedefining Alpha and Beta in Hedge Fund Returns Yazann Romahi, PhD, Managing Director Global Head of Research & Quantitative Strategies Asset Management Solutions, JPMorgan Asset Management 2013

2. What is today’s talk about?

3. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

4. Understanding alpha and beta • Risk premium: • Beta is the return that can be explained by any systematic exposure to an economic risk premium Pre-1975 1975 1993 1997 Bogle launches first index fund Fama-French 3 factor model Carhart 4 factor model Stock selection Key to Equity Return Equity Beta as a Growth Risk Premium Investable Size & Value identified as separate risk premia Momentum described as a persistent risk premium α α α α β βValue βSmall Cap βMomentum β β βValue βSmall Cap Source: J.P. Morgan Asset Management. For illustrative purposes only.

5. Alternative Beta: Definition Alternative Investments Traditional Investments Alternative beta captured through systematic risk exposures Traditional beta captured through systematic risk exposures Alpha (inclusive of the illiquidity premium) Alpha Alternative beta is defined as the returns to factor risks uncorrelated to market risk that can be captured through a systematic exposure to an alternative risk premium (often long/short) that forms a component of traditional hedge fund returns For illustrative purposes only.

6. What Alternative Beta is NOT! • Alternative Beta is NOT Hedge Fund Replication • We will show in this presentation how a large portion of hedge fund returns can be captured through traditional beta exposures • The aim of Alternative Beta is to capture the component of hedge fund returns that is a beta uncorrelated to traditional beta Just because hedge fund indices can be replicated does not mean that they should be replicated

7. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

8. Merger Arbitrage • What is it? • Merger arbitrage involves the hedge fund manager buying into the stock of a company subject to a takeover bid while shorting the stock of the acquirer company • Source of “Alpha”? • Ability of manager to limit exposure to “failed” deals through research • Effectiveness of “alpha” overlay limited due to necessity of portfolio concentration (there are typically 80-100 investable deals globally at any one time)

9. What is Merger Arb? • 3G Capital looked to acquire Burger King and made an offer on 2/9/2010 • Given that this was a friendly deal with a high likelihood of success, the premium available was limited. We bought the stock at USD 23.59, selling it to 3G Capital for USD 24 • The deal completed on October 20th and thus earned 1.7% • While this may initially sound low, this was over a 2 month period roughly equating to an annualised figure of over 10% Price sold bought Source: Bloomberg October 2010 For illustrative purposes only. The inclusion of the securities mentioned above is not to be interpreted as recommendations to buy or sell.

10. Example of failed bid: MacArthur Coal • Peabody Energy make an unsolicited offer for MacArthur Coal on March 30, 2010 at $13 per share • New Hope Corp counter on April 9, 2010 and 4 days later increase their bid by 7.44% to $14.50 per share • Peabody Energy counter on May 10 with an offer of $16 • After Australia introduces a 40% tax on mining profits, Peabody reduces its bid to $15 per share • The board rejects the offer and MacArthur Coal drops to $10.10 • As the market had been expecting counterbids, our entry price was at $14.80 bought Price Source: Bloomberg For illustrative purposes only. The inclusion of the securities mentioned above is not to be interpreted as recommendations to buy or sell. Past performance is not indicative for future performance. The Fund is an actively managed portfolio subject to change.

11. Why is there a risk premium? Average return to a merger arbitrage deal Source: MergerStat, Bloomberg, JPMAM. Jan 1999 to Jul 2011. For illustrative purposes only. Opinions and analysis are JPMAM’s judgment and can be subject to change without notice. Diversification is central to merger arbitrage – more names reduces idiosyncratic risk High levels of merger activity are positive for the strategy

12. Types of merger activity • Deals completed with acquirer stock signals strong valuations • When cash is cheap companies will prefer cash funded acquisitions over stock funded acquisitions Credit bubble – more cash deals Source: Bloomberg, JPMAM as at 31st March 2012. For illustrative purposes only. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice..

13. A diversified portfolio limits downside risk The evidence supporting the hypothesis that the merger arbitrage strategy is akin to a short put is weak. Cash Mergers - Monthly Return of the strategy Stock for Stock Manager - Monthly Return of the strategy Return to merger arbitrage Return to merger arbitrage S&P Monthly Return S&P Monthly Return Source: MergerStat, Bloomberg, JPMAM. Jan 1999 to Jul 2011. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice. 12 12

14. Diversification is key • While North American deals are most active in mergers and acquisitions, European and to a lesser extent Asia Pacific deals do provide a significant amount of diversification • In the current environment, North American deals dominate the portfolio No. of deals Source: Bloomberg. As at 31st March 2012. The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

15. Active Merger Arbitrage vs “Passive” Merger Arbitrage • We create a portfolio of the merger arbitrage “risk premium” – an equally weighted portfolio of stocks subject to takeover (with the corresponding short) • Return is leveraged by approximately 20% Portfolio performance is calculated using a static weight of the asset illustrated above, monthly rebalancing gross of fees. Sources: J.P. Morgan Asset Management, Bloomberg. Analysis period January 1991 to December 2011. Past performance is not a guide to the future.

16. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

17. Understanding alpha and beta • Risk premium: • Beta is the return that can be explained by any systematic exposure to an economic risk premium Pre-1975 1975 1993 1997 Bogle launches first index fund Fama-French 3 factor model Carhart 4 factor model Stock selection Key to Equity Return Equity Beta as a Growth Risk Premium Investable Size & Value identified as separate risk premia Momentum described as a persistent risk premium α α α α β βValue βSmall Cap βMomentum β β βValue βSmall Cap Source: J.P. Morgan Asset Management. For illustrative purposes only.

18. Equity Long Short Index is a combination of risk premia • Equity Long/Short index is essentially a combination of a number of factor risks: • Static 75% weight to MSCI World • Equal allocations to a number of risk premia including the value premium, size premium, momentum and minimum volatility • The importance of understanding the nature of alternative beta allows the investor to distil the truly uncorrelated factor exposures from those that may be doubling up exposure elsewhere in the portfolio Portfolio performance is calculated using a static weight of the asset illustrated above, monthly rebalancing gross of fees. Past performance is not a guide to the future. Sources: JP Morgan Asset Management, Bloomberg. Analysis period January 1995 to December 2012.

19. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

20. HFRI Equity Market Neutral • Equity Market Neutral can be captured with an equal risk exposure to Market Neutral Value and Market Neutral Momentum. Coupled with a MSCI World Beta of 0.1, this gives us an R2 of 45%

21. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

22. HFRI Short Bias • HFRI Short Bias can be captured with a full risk exposure to Market Neutral Value (100% gross leverage). In addition is an equity beta of -0.75. Together, this gives us an R2 of 85%

23. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

24. HFRI Emerging Markets • HFRI Emerging Markets can be captured with a full risk exposure to MSCI EM with a small bias to Momentum (market neutral) and Minimum Volatility (market neutral). R2 = 85.7%

25. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

26. HFRI Convertible Arbitrage • R2 = 67%. Long CB, Long HY and long Investment Grade Credit; Short Duration; Short Equity

27. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

28. HFRI RV Fixed Income Corporate Index • R2 = 68%. Long HY (mainly) with some Investment Grade Credit and Short Duration

29. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

30. A significant amount of “alpha” from hedge funds can be attributed to systematic factors One of the advantages of investing in hedge funds is accessing these uncorrelated sources of risk premia We seek to provide a liquid, transparent alternative to access these uncorrelated sources of return Seeing through the alpha smokescreen . . . Alternative Beta Alpha Traditional Beta Equity Premium Commodity (GSCI) Small Cap Premium Relative Bond Carry Manager Driven Non-systematic Idiosyncratic High Frequency Relative Bond Yield Curve Credit Premium Emerging Debt Value Premium Term Premium Emerging Equity Convertible Arbitrage Equity Momentum REIT Commodities Roll Yield Merger Arbitrage Commodities Momentum Forward Rate Bias FX Momentum Increasing order of complexity For illustrative purposes only. The targets and aims provided above are the Investment Manager’s targets and aims only and are not part of the Funds investment objective and policy as stated in the Fund’s prospectus. There is no guarantee that these targets and aims will be achieved. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.

31. Alternative beta have had low correlations to traditional beta Sources: J.P. Morgan Asset Management, Bloomberg, UBS Global Focus Convertible Bond index, Merger Stat, Citigroup WGBI Index. Analysis period January 1998 to December 2012.

32. Possible uses of alternative beta solutions Source: J.P. Morgan Asset Management. For illustrative and discussion purposes only

33. Alternative Beta as a component of a hedge fund allocation • Alternative Beta can be used in a core/satellite approach to reduce the overall fee structure of the solution while improving its liquidity profile Alternative Alpha 1-2 managers Diversified by attachment point and peril 1-2 managers Diversified by strategy and instrument Alternative Beta Core Component in Alternative Beta • A number of liquid hedge fund styles can be replaced by a lower cost, highly liquid component 1-4 managers Diversified by style and instrument Alternative Beta 1-3 managers Diversified by style and instrument 1-3 managers Diversified across markets Satellite exposures to idiosyncratic alpha • Satellite exposures to managers that deliver true idiosyncratic risk or exposure to illiquidity premia 1-3 managers Diversified by style and market As of December 31, 2012. Allocations are made at the manager's discretion and can be changed without notice. Manager count does not include investments in internal programs and managed co-investments. Strategy allocation information is estimated through December 31, 2012 and has been rounded.

34. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

35. A large competitor • Competitor’s excellent performance over the past 4 years can be entirely explained by a fairly simple bet as highlighted by the replication above • The “Factor Model Portfolio” is a portfolio that is 2/3rds Investment Grade Credit (with the duration hedged out) plus 1/3rd High Yield (R2=76%). There does also appear to be some currency momentum trading in there as well and a small amount of infrastructure equity • While we are not trying to detract from the fact that they successfully made that bet, the point is that it looks like they’ve had essentially one bet on for 4 years with a little bit of noise around it

36. Overview • What is Alternative Beta • Equity Based Hedge Funds • HFRI Merger Arbitrage • HFRI Equity Hedge (Long/Short) • HFRI Equity Market Neutral Index • HFRI Short Bias Index • HFRI Emerging Markets Index • Fixed Income Hedge Funds • HFRI Convertible Bond Arbitrage • HFRI RV Fixed Income Corporate Index • Alternative Beta – NOT hedge fund replication • An aside: Reverse Engineering Your Competitors • To Index or not to Index

37. What Makes a Good Benchmark? • Investable • Appropriate • Informed Opinion • Unambiguous • Specified in advance

38. Have we captured the merger arbitrage hedge fund style? +15.83% (net of C share class fees) +15.26% (net of fees of typically 2/20) • Beta to MSCI World is 0.09 • Volatility is 2.95% compared to 15.80% for the MSCI World index Source: HFR, JPMAM, Bloomberg. As at 30th April 2013. * Inception Date – July 2009, performance is cumulative. Fees and charges for the C share class as follows: No initial charge, 0.75% annual management and advisory fee, 0.20% operating and administrative expenses and no redemption charge. performance of the merger arbitrage strategy within the JPMorgan Funds - Systematic Alpha fund to 31/03/11 and actual performance of the JPMorgan Investment Funds – Global Merger Arbitrage Fund thereafter.The Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided are the Investment Manager’s targets and aims only and are not part of the Fund’s investment objective and policy as stated in the Fund’s Prospectus. Merger arbitrage strategy since inception (*): HFRI ED: Merger arb index

39. Appendix

40. Long/short equity: back-tested performance • In line with the hedge fund style, 2009 was poor • However 2010 was positive and subsequent gains have taken the fund above its previous peak Historical performance analysis Live performance*→→ Source: Factset, Bloomberg, J.P. Morgan Asset Management, 30th April 2013. For illustrative purposes only. Fund inception 1 July 2009. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The back-tested period consists of the performance of the Equity Long/Short (beta neutral) strategy. The model captures the alternative risk premia embedded in the style by going long value stock with positive momentum subject to quality constraints. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Past performance is not indicative of future results. MSCI: Morgan Stanley Capital International. *Performance includes backtested data from 31/01/96 to 30/06/09 and performance of the equity long/short strategy within the JPMorgan Funds - Systematic Alpha fund thereafter. 

41. Equity Long/Short - diversified, systematic capture of risk premia Value premium Momentum • Risk Premium • Strategy: • Long “cheap” stocks, Short “expensive” stocks (as measured by P/E, Div Yld etc) • These factors form the backbone of many quantitative & qualitative equity products and drive most equity investment philosophies. • Risk Premium • Strategy: • Buy small cap stocks; short large cap stocks • Return Chasing & Market Bias • Strategy: • Long positive earnings revision stocks, short negative revision stocks • Buy stocks whose momentum is in the top decile while shorting those in the bottom decile • Behavioural bias • Strategy: • Long positions with decreasing accruals, short stocks with growing accruals; • Long positions with low beta, short stocks with high beta Size premium Quality For illustrative and discussion purposes only. The Fund is an actively managed portfolio; holdings, sector weights, allocations and leverage as applicable, are subject to change and the Fund is managed to internal guidelines which are not absolute and can change over time. The targets and aims provided above are the Investment Manager’s targets and aims only and are not part of the Funds investment objective and policy as stated in the Fund’s prospectus. There is no guarantee that these targets and aims will be achieved.

42. The Value Premium : 1927-present Fama-French Value: 1927-present • Academic explanations remain incomplete at best • EMH: Fama-French describe it as a priced risk factor. They argue that stocks with high book-market are more likely to be subject to financial distress and more correlated to the business cycle • Behavioral finance: the literature here suggests that cognitive biases underlying investor behaviour are at the root of the premium. Specifically irrational investors tend to have exaggerated hopes for growth/glamour stocks and overly pessimistic outlook on value stocks • Outlook: The increasing prevalence of ETFs and of passive market investments is exacerbating the premium

43. The Value Premium : 1927-present • One of the most interesting aspects of the value premium is the positive skew it brings in addition to its positive excess return over time • It should also be noted that as seen in the returns since 1927, the value premium has not diminished since Graham and Dodd’s 1934 treatise.

44. Fama-French Size Premium Fama-French Size: 1927-present • The size effect can go through long periods of underperforms • Outlook: • The growth of ETFs and the growing acceptance of beta is in fact exacerbating both the value and size premia

45. The Size Premium : 1927-present • Drawdowns are significant with long periods of underperformance • However, as seen with the value premium, the size premium is a positively skewed strategy which has significant benefit in a portfolio of exotic beta

46. Momentum : 1927 - present Fama-French Momentum: 1927-present • Momentum exists in all financial time series • The persistence of this anomaly is the biggest threat to EMH • Behavioural finance advocates offer explanations based on non-rational behaviour generating abnormal inertia • Outlook: • Momentum generally performs poorly at market turning points • The question going forward is whether we are entering into an environment with shorter economic cycles

47. Momentum Distribution and Skew : 1927-present • The momentum factor exhibits significant negative skew • Can it therefore be considered compensation for bearing negative skew?

48. Momentum Backtest : 1990 – present • From 1990, redefine it in sector neutral, country neutral momentum • The results are similar and the negative skew is still pronounced

49. Low Risk Investing – Beta and Volatility • The outperformance of low beta/volatility stocks over high beta/volatility stocks is one of the biggest challenges to CAPM • Unsurprisingly, all explanations in the literature are behavioural based. • Most active money is delegated to managers whose performance is measured relative to a market index. As these managers are usually limited in any leverage they may use, low beta stocks will therefore look risky. • Investors tend to favour higher volatility stocks because they underestimate the risk of stocks that offer the allure of a really high payout – highly volatile stocks. An alternative but related explanation is that they favour stocks that consistently are in the news (typically high volatility stocks)

50. Low Beta as an Investment Signal • Creating a portfolio based on low beta stocks while hedging with high beta stocks add value though the turnover is relatively high • The strategy experiences significant underperformance during “dash to trash” rallies • Surprisingly, the strategy is also negatively skewed and the quintile dispersion is not monotonic as only the extremes appear to add value