Transcript Presentation Name Company (Client) Name Date

Democratization of Hedge Funds
Redefining 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
What is today’s talk about?
1
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
2
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
Stock selection
Key to Equity Return
1975
1993
1997
Bogle launches
first index fund
Fama-French
3 factor model
Carhart
4 factor model
Equity Beta as a Growth
Risk Premium Investable
Size & Value identified
as separate risk premia
α
α
β
βValue
βSmall Cap
β
α
Source: J.P. Morgan Asset Management. For illustrative purposes only.
3
Momentum described
as a persistent risk premium
α
β
βValue
βSmall Cap
βMomentum
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.
4
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
5
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
6
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)
7
What is Merger Arb?
25
Burger King
23

3G Capital looked to acquire Burger King and
made an offer on 2/9/2010
21
19

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%
17
Price

15
24
Burger King
sold

While this may initially sound low, this was
over a 2 month period roughly equating to an
annualised figure of over 10%
bought
23.5
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.
8
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.
9
Why is there a risk premium?

Diversification is central to merger arbitrage – more names reduces idiosyncratic risk

High levels of merger activity are positive for the strategy
Average return to a merger arbitrage deal
60%
Percent of deals
50%
40%
30%
20%
10%
0%
Return per merger 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.
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
Percentage of announced cash deals
100%
Credit bubble – more cash deals
90%
80%
70%
60%
50%
Dot com bubble – more stock deals
40%
30%
20%
10%
0%
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
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..
11
A diversified portfolio limits downside risk
Cash Mergers - Monthly Return of the strategy
Stock for Stock Manager - Monthly Return of the strategy
Return to merger arbitrage
Return to merger arbitrage
4.00%
4.00%
3.00%
3.00%
2.00%
2.00%
1.00%
1.00%
S&P Monthly Return
S&P Monthly Return
-20.00%
-15.00%
-10.00%
0.00%
-5.00%
0.00%
-20.00%
5.00%
10.00%
15.00%
-15.00%
-10.00%
0.00%
-5.00%
0.00%
5.00%
-1.00%
-1.00%
-2.00%
-2.00%
-3.00%
-3.00%
-4.00%
The evidence supporting the hypothesis that the merger arbitrage strategy is akin to a short put is weak.

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
10.00%
15.00%
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
1200
Asia Pacific (Developed)
Western Europe
North America
900
600
300
0
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
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.
13
Jan-11
Jan-12
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)
180%
160%

Return is leveraged by approximately 20%
140%
120%
100%
80%
HFRI Merger
Arbitrage
Systematic merger arbitrage
Return
7.77%
7.97%
Risk
3.62%
5.30%
1.16
0.83
8.27%
12.57%
21
21
IR
Drawdown
Longest
underperformance
60%
40%
20%
0%
Jan-94
Jul-96
Jan-99
Jul-01
Systematic Merger Arbitrage
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.
14
Jan-04
Jul-06
Jan-09
Jul-11
HFRI Merger Arb
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
15
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
Stock selection
Key to Equity Return
1975
1993
1997
Bogle launches
first index fund
Fama-French
3 factor model
Carhart
4 factor model
Equity Beta as a Growth
Risk Premium Investable
Size & Value identified
as separate risk premia
α
α
β
βValue
βSmall Cap
β
α
Source: J.P. Morgan Asset Management. For illustrative purposes only.
16
Momentum described
as a persistent risk premium
α
β
βValue
βSmall Cap
βMomentum
Equity Long Short Index is a combination of risk premia
200%

Equity Long/Short index is essentially a
combination of a number of factor risks:
–
–

150%
Static 75% weight to MSCI World
Equal allocations to a number of risk premia including the
value premium, size premium, momentum and
minimum volatility
100%
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
50%
0%
-50%
Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
75% MSCI World + 60% Alt Beta
HFRI Equity Hedge Index
MSCI World
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.
17
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
18
HFRI Equity Market Neutral
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
100%
80%
60%
40%
20%
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
0%
Portfolio

Portfolio
Factor Model
Factor Model
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%
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 Short Bias
30%
80%
20%
60%
40%
10%
20%
0%
0%
-20%
-20%
-40%
-30%
-60%
Portfolio

Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
-10%
Factor Model
Portfolio
Factor Model
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%
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 Emerging Markets
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
250%
200%
150%
100%
50%
0%
Portfolio

Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
-50%
Factor Model
Portfolio
Factor Model
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%
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 Convertible Arbitrage
15%
300%
10%
250%
5%
200%
0%
150%
-5%
100%
-15%
50%
-20%
0%
Portfolio

Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
-10%
Factor Model
Portfolio
Factor Model
R2 = 67%. Long CB, Long HY and long Investment Grade Credit; Short Duration; Short Equity
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
Portfolio

Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
HFRI RV Fixed Income Corporate Index
10%
200%
5%
150%
0%
100%
-5%
-10%
50%
-15%
0%
Factor Model
Portfolio
R2 = 68%. Long HY (mainly) with some Investment Grade Credit and Short Duration
27
Factor Model
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
Seeing through the alpha smokescreen . . .
Traditional Beta
Alternative Beta
Alpha
Equity Premium
Commodity (GSCI)
Small Cap Premium
Relative Bond Carry
Manager Driven
Credit Premium
Emerging Debt
Value Premium
Relative Bond Yield Curve
Non-systematic
Term Premium
Emerging Equity
REIT
Equity Momentum
Convertible Arbitrage
Idiosyncratic
Merger Arbitrage
Commodities Roll Yield
Commodities Momentum
Forward Rate Bias
High Frequency
FX Momentum
Increasing order of complexity

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
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.
29
Alternative beta have had low correlations to traditional beta
MSCI World
MSCI EM
WGBI
High Yield
EMBI
GSCI
Value
-0.14
-0.13
-0.05
-0.09
-0.16
0.06
Momentum
0.30
0.22
0.04
0.12
0.14
0.01
Size
0.19
0.32
-0.07
0.31
0.22
0.12
Low beta / minimum volatility
-0.51
-0.46
0.05
-0.36
-0.25
-0.06
Convertible bond arbitrage
0.13
0.30
0.02
-0.01
0.36
0.08
Systematic merger arbitrage
0.47
0.52
0.00
0.41
0.45
0.25
Long/Short G7 Term Premium
-0.13
-0.05
0.02
0.01
0.01
-0.10
Long/Short G7 Carry
0.11
0.07
0.10
0.03
0.22
0.08
FX Carry
0.40
0.48
-0.03
0.39
0.26
0.30
FX Momentum
0.02
0.08
-0.05
-0.06
-0.14
0.08
Commodities Roll Yield
0.10
0.12
0.21
0.21
0.12
0.20
Commodities Momentum
0.01
-0.02
0.16
0.04
0.05
0.22
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.
30
3
Possible uses of alternative beta solutions
Question
How can we help?
Institutional client unable to access traditional alternatives
due to high costs, illiquidity and/or a lack of transparency
(manager risk)
Ability to provide alternative solutions in a low cost, liquid, and
transparent fashion
Hedge Fund investor looking to increase the liquidity
profile of their hedge fund investments
Analyse current exposures in their portfolio. Help them understand
what alternative factors they may already have and where additional
exposure may be beneficial. When requiring liquidity, a core/ satellite
approach to alternative beta / high conviction alpha may be
appropriate, thus allowing the client to increase exposure to
alternatives while maintaining liquidity.
Hedge Fund investor in the process of searching for a
high conviction manager and would like to hold the
alternative beta exposure in the interim
Liquidity allows users to access the hedge fund style while they
search for a high conviction manager. Similarly, daily liquid vehicles
can be used for factor timing.
Source: J.P. Morgan Asset Management. For illustrative and discussion purposes only
31
3
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
Alternative Beta
1-2 managers
Diversified by
attachment point and
peril
1-2 managers
Diversified by strategy
and instrument
Non-Spread
Credit, 15%
Reinsurance,
15%
Core Component in Alternative Beta

A number of liquid hedge fund styles can
be replaced by a lower cost, highly liquid
component
Quantitative,
12%
1-3 managers
Diversified by
style and
instrument
Emerging
Markets, 22%
Alternative
Beta
Commodities
, 10%
Satellite exposures to idiosyncratic alpha

Satellite exposures to managers that
deliver true idiosyncratic risk or exposure
to illiquidity premia
Traditional
Macro, 26%
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.
32
1-4 managers
Diversified by style
and instrument
1-3 managers
Diversified across
markets
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
33
A large competitor
80%
70%
60%
Return
Risk
Sharp Ratio
Max Drawdown
Portfolio
Factor Model
13.7%
7.2%
1.9
5.1%
13.7%
8.1%
1.3
7.1%
9%
6%
3%
50%
0%
40%
30%
-3%
20%
-6%
10%
0%
-10%
Jan-09
-9%
Jan-09
Jan-10
Portfolio
Jan-11
Jan-12
Jan-10
Jan-11
Portfolio Excess Return
Jan-12
Model Excess Return
Factor Model

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 1/3 rd 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
34
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
35
What Makes a Good Benchmark?

Investable

Appropriate

Informed Opinion

Unambiguous

Specified in advance
36
Have we captured the merger arbitrage hedge fund style?
Merger arbitrage strategy since inception (*):
+15.83% (net of C share class fees)
HFRI ED: Merger arb index
+15.26% (net of fees of typically 2/20)
25%
JPM Merger Arb
HFRI Merger Arb Index
HFRX Merger Arb Index
20%

Beta to MSCI World is 0.09

Volatility is 2.95% compared to 15.80% for the
MSCI World index
15%
10%
5%
0%
Apr-13
Jan-13
Oct-12
Jul-12
Apr-12
Jan-12
Oct-11
Jul-11
Apr-11
Jan-11
Oct-10
Jul-10
Apr-10
Jan-10
Oct-09
Jul-09
-5%
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.
Appendix
38
Long/short equity: back-tested performance

In line with the hedge fund style, 2009 was poor
Historical performance analysis
400%

However 2010 was positive and subsequent
gains have taken the fund above its previous
peak
350%
300%
Equity
Long/Short
MSCI
World
250%
Excess return (annualised)
6.0%
4.1%
200%
Risk
5.9%
16.0%
150%
IR
1.01
0.05
100%
10.9%
55.4%
50%
Periods to
30th
April 2013
Maximum drawdown
Beta
-0.11
Live performance*→→
Equity long/short
MSCI World
0%
Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
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.
Equity Long/Short - diversified, systematic capture of risk premia
Value premium
Momentum

Risk Premium

Return Chasing & Market Bias

Strategy:

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.
Size premium
–
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
Quality

Risk Premium

Behavioural bias

Strategy:

Strategy:
–
Buy small cap stocks; short large cap stocks
–
Long positions with decreasing accruals, short stocks with growing
accruals;
–
Long positions with low beta, short stocks with high beta
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.
The Value Premium : 1927-present
Fama-French Value: 1927-present
450%
Academic explanations remain incomplete at
best
250%
200%
150%
100%
50%
0%
Outlook: The increasing prevalence of ETFs and of
passive market investments is exacerbating the premium
-50%
41
Jan-11
Jan-05
Jan-99
Jan-93
Jan-87
Jan-81
Jan-75
Jan-69
Jan-63
Jan-57
Jan-51
-100%
Jan-45
–
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
300%
Jan-39
–
350%
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
Jan-33
–
400%
Jan-27

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
8.00%
Value Quintile Returns vs Universe
6.00%

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.
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
Quintile 1
42
Quintile 2
Quintile 3
Quintile 4
Quintile 5
Fama-French Size Premium
Fama-French Size: 1927-present
250%
Outlook:
The growth of ETFs and the growing acceptance of beta is in
fact exacerbating both the value and size premia
150%
100%
50%
0%
-50%
43
Jan-11
Jan-05
Jan-99
Jan-93
Jan-87
Jan-81
Jan-75
Jan-69
Jan-63
Jan-57
Jan-51
Jan-45
-100%
Jan-39
–
200%
Jan-33

300%
The size effect can go through long periods of
underperforms
Jan-27

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
44
Momentum : 1927 - present
400%
–
The persistence of this anomaly is the biggest threat to EMH
–
Behavioural finance advocates offer explanations based on nonrational behaviour generating abnormal inertia
350%
300%
250%
Outlook:
–
Momentum generally performs poorly at market turning points
200%
–
The question going forward is whether we are entering into an
environment with shorter economic cycles
150%
100%
50%
45
Jan-11
Jan-05
Jan-99
Jan-93
Jan-87
Jan-81
Jan-75
Jan-69
Jan-63
Jan-57
Jan-51
Jan-45
Jan-39
0%
Jan-33

Fama-French Momentum: 1927-present
Momentum exists in all financial time series
Jan-27

Momentum Distribution and Skew : 1927-present

The momentum factor exhibits significant negative skew

Can it therefore be considered compensation for bearing negative skew?
46
Momentum Backtest : 1990 – present
2.50
2.00
1.50
1.00
0.50
Momentum Quintile Returns vs Universe
6.00%
Jan-10
Jan-08
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
2.00%
Jan-92
Jan-90
0.00
4.00%
0.00%
-2.00%

From 1990, redefine it in sector neutral, country neutral momentum

The results are similar and the negative skew is still pronounced
-4.00%
-6.00%
Quintile 1
Quintile 2
Quintile 3
Quintile 4
Quintile 5
47
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)
48
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
49
Macro Based Risk Premia
Global Macro has Significant Dispersion Amongst Underlying Managers

In the macro space, there isn’t a single premium that can explain the style so we focus instead on
understanding the different risk premia that exist

Here we list a number of risk premia common in the macro space
–
Bond Futures: Although the term premium is considered a traditional beta, converting this into a long/short duration neutral
relative term premium transforms this into an exotic beta
–
FX: One of the most commonly known behavioural biases in FX is the Forward Rate Bias. We implement this amongst both
G10 & EM countries and build a relative momentum model to augment this
–
Commodities: The term structure in commodities generally reflects both expected changes in spot prices as well as an
insurance premium


If hedgers are net short, the term structure is likely to be backwardated* and thus a long position will earn a risk premium
Likewise, if hedgers are net long, then contango* is likely and thus short positions earn a risk premium
*Please see the Glossary of Terms in Appendix.
The aims and objectives provided above are the investments manager’s aims and objectives and do not necessarily reflect the investment objective and policy of the Fund as stated in the Prospectus.
There is no guarantee that these aims and objectives will be achieved. Opinions and analysis offered constitute JPMAM’s judgment and are subject to change without notice.
The Macro risk premium in our strategy


Fixed income
–
Long the long end of steepest curves and short the long end of the flattest curves
–
Long the highest carry bond markets and short the lowest carry bond markets
–
7 developed bond markets
Currency
–
10 developed market currencies – momentum and carry negatively correlated


–

Momentum – Price Momentum to capture autocorrelation in price series and equity momentum to capture a flow proxy
Carry – Forward rate bias: Long the highest yielding currencies with rising rates and short the lowest yielding currencies with
decreasing rates
20 Emerging Market Currencies: Forward Rate Bias Strategy though no positions taken in currencies of countries where the
CDS prices are implying an implied probability of default greater than 15%
Commodities
–
20 commodities - constituents of GSCI and DJUBS indices


Roll Yield – long backwardated commodities and short those in contango
Momentum – Commodities exhibit the highest autocorrelation of all financial timeseries
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.
Fixed Income Macro Premia
Fixed Income Backtest Performance
28%
23%
Bond Bond
Annualised return
1.08%
Volatility
1.49%
Sharpe Ratio
0.73
Fixed Income live track record
Live performance*→→
18%
7.0%
Bond Bond
6.0%
5.0%
4.0%
13%
3.0%
2.0%
8%
1.0%
3%
0.0%
Apr-13
Jan-13
Oct-12
Jul-12
Apr-12
Jan-12
Oct-11
Jul-11
Apr-11
Jan-11
Oct-10
Jul-10
Apr-10
Jan-10
Oct-09
-1.0%
Jul-09
Jan-95
Dec-95
Nov-96
Oct-97
Sep-98
Aug-99
Jul-00
Jun-01
May-02
Apr-03
Mar-04
Feb-05
Jan-06
Dec-06
Nov-07
Oct-08
Sep-09
Aug-10
Jul-11
Jun-12
-3%

Since inception, the factors within the fixed income strategy have been giving offsetting signals.

For this reason, risk taken within the strategy has been low, leading to performance that has been broadly flat.
Source: Bloomberg, J.P. Morgan Asset Management, as at 30th April 2013. Fund inception 1 July 2009. For illustrative purposes only. Past performance is not indicative of future results.
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 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. For the purposes of the back-test, the model positions were generated historically using data available at the time and run forward. Performance
includes backtested data from 31/12/94 to 30/06/09 and performance of the Fixed income strategies within the JPMorgan Funds - Systematic Alpha fund
thereafter.
FX Macro Premia
FX G10 backtest & live performance
240%
Live performance*→→
FX G10
190%
Annualised return
5.41%
Volatility
5.00%
Sharpe Ratio
FX EM backtest & live performance
1.08
130%
110%
90%
Live performance*→→
FX EM
Annualised return
4.46%
Volatility
5.03%
Sharpe Ratio
0.89
140%
70%
50%
90%
30%
40%
10%
-10%
Apr-97
Jan-98
Oct-98
Jul-99
Apr-00
Jan-01
Oct-01
Jul-02
Apr-03
Jan-04
Oct-04
Jul-05
Apr-06
Jan-07
Oct-07
Jul-08
Apr-09
Jan-10
Oct-10
Jul-11
Apr-12
Jan-13
May-91
May-92
May-93
May-94
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
May-09
May-10
May-11
May-12
-10%
Source: Bloomberg, J.P. Morgan Asset Management, as at 30th April 2013. Fund inception 1 July 2009
For illustrative 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 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. 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. *Performance includes backtested data from 31/04/91 to 30/06/09 and performance within the Systematic Alpha Fund thereafter.
Commodity Macro Premia
Commodity Backtest performance
110%
Commodities

In the past, a significant proportion of the roll yield
could be captured by being long the commodity due
to most commodities being in backwardation.

This is no longer true, with most commodities today
being in contango. Indeed the most backwardated
commodity is soybeans, with an annualised yield of
14.8%. In comparison, the commodity in greatest
contango, lean hogs, has a negative yield of 33.9%.
90%
70%
50%
30%
Annualised return
4.39%
Volatility
5.00%
IR
0.88
10%
Aug-97
May-98
Feb-99
Nov-99
Aug-00
May-01
Feb-02
Nov-02
Aug-03
May-04
Feb-05
Nov-05
Aug-06
May-07
Feb-08
Nov-08
Aug-09
May-10
Feb-11
Nov-11
Aug-12
-10%
Source: Bloomberg, J.P. Morgan Asset Management, 28th February 2013.
For illustrative purposes only. Past performance is not indicative of future results. 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 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. For the purposes of
the back-test, the model positions were generated historically using data available at the time and run forward.
More on CBs
What is a convertible bond?
Equity
Option
Debt
Equity Option Characteristics:
Debt Characteristics:

Principle repayment at a future date

Periodic coupon payments

Priced as a percentage of par

Often “puttable” at investor’s option

Often callable at issuer’s option
Source: KBC Financial Products
57

Conversion into shares during
the life of the bond

Fixed conversion price, at a
premium to the current share
price

Fixed number of shares per
bond
Spectrum of convertible profiles

Convertibles can exhibit a number of different profiles, depending upon the value of the embedded optionality
Equity-like
Theoretical convertible payoff curve
Convertible price
Option is in-the-money, and these securities exhibit a high degree
of equity sensitivity. Equity-like convertibles are most exposed to
changes in the underlying share price
Balanced
Bond-like
convertible
Balanced
convertible
Equity-like
convertible
Convertibl
e Price
Provide a mixture of equity and credit exposure. The convertible
will be trading slightly above the bond floor, which will provide
some protection on the downside if equity prices decline; in a
positive scenario, delta will increase quickly and the optionality will
increase in value, providing significant upside participation
Bond Floor
Conversion
Premium
Parity
Bond-like
Option is significantly out-of-the money and the probability of
conversion is low. These securities have little equity sensitivity,
and the primary driver of returns is the coupon and yield to
maturity, as well as any changes in credit conditions
Equity price
Definitions: Equity-like = vanilla convertibles with premium < 15%; Balanced = convertibles with a premium < 100% and an annualised premium < 20%; Bond-Like = convertibles with a
premium > 100% or annualised premium > 20%
58
Convertible Bonds : A Hybrid Asset Class

Convertible Bonds are a hybrid asset class
made up of several risk premia:

High Yield

Small Cap Premium

Equity Risk Premium

Embedded Optionality (can be
considered a liquidty risk premium)
Portfolio performance is calculated using a static allocation based on the weights illustrated above with monthly rebalancing and gross of fees.
Sources: Please see disclosure slide for data sources: Analysis period January 1994 to December 2011.
Past performance is not a guide to the future.
59
Convertible Bond Arbitrage
140%


Convertible Bond (CB) arbitrage is a hedge fund
style where, like merger arbitrage, there exists a
common risk factor amongst the participants.
120%
100%
CB’s trade at a discount to the sum of its parts –
straight bond plus a call option on the underlying.
80%
The premium is essentially an illiquidity and
small cap. premium.
40%
–
–
To eliminate this, the arbitrageur will typically
look to hedge the equity and duration sensitivity.
60%
20%
0%
Jan-96 Oct-97
Jul-99
Apr-01 Jan-03 Oct-04
HFRI CB Arb
Jul-06
Apr-08 Jan-10
CB Arb Replicating Portfolio
Convertible bond arbitrage
MSCI World
Return
6.1%
3.3%
Risk
7.8%
16.3%
IR
0.78
-0.01
19.7%
55.4%
Drawdown
Correlation matrix
Convertible bond
arbitrage
MSCI World
MSCI EM
WGBI
High Yield
EMBI
GSCI
-0.02
0.05
0.16
0.28
0.24
0.04
Portfolio performance is calculated using a static allocation based on the weights illustrated above with monthly rebalancing and gross of fees.
Sources: Please see disclosure slide for data sources: Analysis period January 1994 to December 2011.
Past performance is not a guide to the future.
60
Cross-Correlation between and within traditional and alternative beta
MSCI
World
Value
Mom.
Size
Min.
Volatility
Merger
Arb.
WGBI
EMBI
Term
Prem.
Real
Yield
High
Yield
Convert.
Arb.
REITs
MSCI World
1.0
Value
-0.2
1.0
Momentum
-0.3
-0.1
1.0
Size
0.1
-0.4
0.1
1.0
Minimum volatility
-0.2
0.1
0.1
0.0
1.0
Merger arb.
0.4
-0.2
0.0
0.3
0.0
1.0
WGBI
-0.1
0.1
0.2
-0.2
0.0
-0.1
1.0
EMBI
0.5
-0.1
-0.1
0.1
-0.1
0.4
0.2
1.0
G7 Term Premium
-0.2
-0.1
0.1
-0.1
0.2
0.0
-0.0
-0.1
1.0
G7 Real Yield
0.0
0.0
0.0
0.0
-0.1
0.0
-0.0
0.0
-0.3
1.0
High Yield (spread)
0.6
0.0
-0.4
0.3
-0.1
0.3
0.0
0.5
-0.2
0.0
1.0
Convertible bond arb.
-0.2
-0.4
0.4
0.4
0.0
0.2
0.1
0.2
0.1
0.0
0.1
1.0
REITs (beta hedged)
-0.3
0.5
-0.1
0.2
0.1
-0.1
0.1
0.0
-0.2
0.0
0.1
-0.1
1.0
GSCI
0.3
0.0
0.1
0.1
0.1
0.2
-0.1
0.2
-0.1
-0.1
0.2
-0.1
-0.1
Sources: Please see disclosure slide for data sources: Analysis period January 1991 to December 2011.
61
GSCI
1.0
Bibliography
62
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63
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
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
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
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
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
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
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
[21] Galati, G and K Tsatsaronis, (1996), “The information content of implied Volatility from Currency Options”, Bank of
International Settlements

[22] Amin K.I and V.K. Ng, (1997), “Inferring Future Volatility from the Information in Implied Volatility in Eurodollar Options:
A New Approach”, Review of Financial Studies, Vol 10, No. 2, pp 333-367

[23] Christensen, B.J and N.R. Prabhala, (1998), “The Relation Between Implied and Realized Volatility”, Journal of
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
[24] Bollen N, Whaley R, (2004), “Does Net Buying Pressure Affect the Shape of the Implied Volatility Functions?”, Journal
of Finance, vol 59(2), pp.711-753.
What are we doing at JPMorgan?

Focusing on the creation of liquid vehicles to enable access to
alternative beta

Creation of multistrategy diversified solutions for those wanting
diversified liquid alternatives exposure

Recent media interest has resulted in more interest
–
Significant coverage in prominent media such as NRPN and FTfm, IPE
amongst others
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