Funds of Hedge Funds Q3 Update, December 2008

Funds of Hedge Funds Q3 Update, December 2008 In what has been the worst year on record for funds-of-hedge-funds (FOHFs) only two of those we rate made money over the nine months to end-september 2008. These are GAM Trading II (up 2.4%) and Stillwater Matrix Offshore (+3.8%). Both are single strategy FOHFs. GAM Trading II invests in managed futures traders and global macro funds, while Stillwater Matrix Offshore is a fund of asset-based lending funds. The only other positive strategy has been short selling. However, we do not know of any FOHFs that focus solely on this strategy. Short-biased hedge funds are included in portfolios as a hedge to reduce overall underlying net long exposure. Investor disappointment with hedge fund/fohf performance so far this year has led to record withdrawals. HFN estimated recently that hedge fund assets under management declined by 16% in the third quarter to $2.497trn; performance accounting for $348bn of the reduction and investor redemptions for around $128bn. Most of these withdrawals have come from FOHFs (as the dominant investor in hedge funds) in response to withdrawals by their own investors. A significant problem for FOHFs faced with large redemptions is that many of their hedge fund holdings have imposed gates or, in some cases, have even suspended redemptions. Most FOHFs we rate have credit lines available to continue meeting redemptions where they are faced with gates or suspended redemptions. However, banks have become less willing to extend borrowing facilities and in some cases are unable to, because of their own balance sheet constraints. Shortly after the end of the third quarter, Permal increased the notice period on its funds from 20 to 95 days (in line with prospectus provisions) after some of the banks that provide credit facilities for its funds gave notice to withdraw, and as the rate of redemptions accelerated. Elsewhere, Notz Stucki has activated a gate on DGC Pendulum (provided for in its prospectus) in response to heavy redemptions from its investors and deteriorating portfolio liquidity, as more and more of its hedge fund holdings put gates on withdrawals. UFG Alteram has changed from daily to weekly dealing in its S&P A rated Alteram Trésorerie Fund and has imposed a gate on any redemptions exceeding 5% in a week. The main reason for the change to weekly dealing is volatility in the market, which can cause NAV estimates to fall outside tolerance limits on accuracy. The gate was considered necessary to "avoid considerable dislocation" of the portfolio and even "the inability to meet reimbursements requested by holders" given the limited liquidity in the portfolio's hedge fund holdings. The most leveraged FOHF we rate is the Cedar Fund. It has stayed open so far, but the premium it pays over Libor increased during the third quarter. This hurt the fund where it was already hurting. Falling returns on its hedge fund holdings combined with investor withdrawals have caused debt-to-nav to rise significantly in the short term, although manager Mark Cachia has taken action that will bring leverage well below the ceiling, depending on whether some of the funds redeemed subsequently impose gates or suspend redemptions. He does not want to change the Cedar Fund's redemption terms if possible, and points out that Erste Bank's commitment to maintaining its investment in the fund provides some stability. So far RMF has coped with investor withdrawals without needing to change any of the dealing terms on its S&P AA rated Four Seasons Strategies fund. Liquidity and transparency are enhanced by around 25% of the holdings being managed accounts. RMF's head of portfolio management, Reto Grau, would like to increase managed accounts to at least half of the portfolio and is currently talking with preferred hedge fund managers about providing these in place of their standard products. Another feature of the third quarter was the abnormally wide range of returns shown by FOHFs, mirroring the extreme volatility in underlying financial markets. Within multistrategy FOHFs, returns range from a 3.8% decline in the Absolute Fund's NAV over the year to end-september to a 34.2% decline in the Cedar Fund. Most of the decline in the latter is due to leverage. Among unleveraged multistrategy FOHFs, Haussmann Holdings saw the biggest decline (-18.0%). However, that is because its mandate is semi-directional and it includes longonly as well as FOHFs. There was also a wide range for those funds investing in long/short equity hedge. Within global long/short, Commerzbank's Comas ELinAS Fund did a relatively good job of preserving capital, down only 6.6%, helped by a small allocation to macro and trading strategies. Jupiter's Merlin Absolute Return Portfolio, a pure global equity long/short FOHF, lost only slightly more (-7.0%). At the other extreme HDF Global Equity Fund lost 26.4%. However, it has a significant allocation to long-only global equity funds. HDF Global Long-Short, which is normally fully invested in equity hedge, fared better (-16.8% over the nine months to end-september 2008). There was an even wider range among funds of European equity hedge funds. Turnstone Europe was the most successful at limiting drawdown, down

6.2% (year to end-september), while HDF lost 29.5%, hurt by a significant allocation to long-only funds. HDF Europe Long-Short Fund, which has negligible long-only, was down 18.6%. Emerging markets was the worst hedge fund strategy, with results ranging from GAM Multi-Emerging Markets, - 16.6%, to HDF Emerging Markets Equity, -39.6% over the year to end- September 2008. Despite record losses and withdrawals, many of the managers we spoke to are more optimistic about the future than ever before. Theta Capital Management's FOHF team believes "the current environment offers outstanding opportunities for those who are able to stay or step in at this point". Charles Hovenden, CIO of Absolute Fund Management, is excited about the future. He thinks next year should present some strong opportunities in convertible arbitrage, distressed and equity hedge, particularly in the US and Europe. Within convertible arbitrage, which has been the worst-performing strategy outside of emerging markets this year, Hovenden believes there may be "a once-in-a-lifetime opportunity for the survivors". Most managers we spoke to believe forced selling will continue to exert downward pressure on strategies. However, Benchmark's CIO, Karen Kisling, thinks that once the current deleveraging has run its course, there will be significant opportunities in convertible arbitrage and long/short equity deep value. She also considers that subprime, ABS and agency mortgage markets are attractive on a medium-term outlook. Legendary hedge fund manager John Paulson, who made billions from shorting subprime assets, has recently started buying them. During the third quarter he launched his Paulson Recovery Fund to buy distressed assets, including equity stakes in financial institutions. A contrasting view comes from David Smith, manager of GAM Diversity and head of the group's multi-manager team. He maintains a negative mediumterm outlook for equities and remains positioned for continued difficult and volatile market conditions. THE ABSOLUTE FUND, A Charles Hovenden, manager of the Absolute Fund, has done a good job of controlling risk during this difficult period for FOHFs. He has limited the fund's year to end-september 2008 loss to 3.8%. Relatively strong capital preservation through market turbulence is partly attributable to the fund's holdings of short-biased equity and short-biased credit managers (9% and 4% respectively). Hovenden is excited about the future. He thinks next year should present some strong opportunities in convertible arbitrage, distressed and equity hedge, particularly in the US and Europe. Heavy redemptions in the pipeline for convertible arbitrage funds (most of them have quarterly redemption notice periods) are likely to weigh on the strategy until well into the first quarter of 2009 in his opinion. However, he believes there may be "a once-in-a-lifetime opportunity for the survivors". The fund has only one distressed manager currently - Southpaw Credit Opportunities (a 2.4% position). Hovenden expects to build up holdings in this area from around the middle of next year. ALTERAM TRÉSORERIE PLUS, A The fund lost 5.2% during the third quarter and is down 1.2% over the nine months to end-september. All the portfolio's hedge fund strategies except managed futures were down during the third quarter and money market fund holdings returned 1.1%. UFG Alteram has changed dealing on a number of its funds, including the S&P A rated Alteram Trésorerie Plus, from daily to weekly. It has also introduced a 5% gate on any outflows exceeding 5% in a week. The main reason for the change to weekly dealing is volatility in the market, which can cause NAV estimates to fall outside of tolerance limits on accuracy. The gate was considered necessary to avoid "considerable dislocation" of the portfolio and even "the inability to meet reimbursements requested by holders" given the limited liquidity in the portfolio's hedge fund holdings. BENCHMARK ALTERNATIVE INVESTMENT FUND - ALTERNATIVE OPPORTUNITIES, A The fund was down by an estimated 10.8% over the year to end-september 2008. According to the fund's manager, Karen Kisling, most holdings were down and long/short equity hedge, emerging markets and convertible arbitrage showed significant losses in the third quarter of 2008. She reports that only a few funds generated positive performances. These were mainly niche allocations, including shipping arbitrage specialist, Global Maritime Investments, as well as the structured finance funds Denholm Hall Russia Arbitrage Fund and Madison Niche Opportunities. Looking forward, Kisling believes the deteriorating economic background and escalating redemptions from hedge funds will limit opportunities in the short term. However, once the current deleveraging has run its course, she believes there are significant opportunities in convertible arbitrage and long/short equity deep value. Kisling also considers that subprime, ABS and agency mortgage markets are attractive on a medium-term outlook. CEDAR FUND, A The third quarter of 2008 was an awful period for the Cedar Fund, which was down by an estimated 30.5%. It accounted for most of the year to end- September 2008 loss of around 34.2%. This is entirely due to the effect of leverage - if there had been no borrowings, the actual loss would have been just under 10%. Additional evidence that the underlying portfolio management has been robust comes from the team's other rated fund, the Max Emerging Markets Alpha Fund, which was down 16.8% over the nine months to end-september and is one of the better-performing funds of emerging markets hedge funds. The investment rationale behind the Cedar Fund is to combine uncorrelated alpha sources and leverage the result. This has worked throughout its sixyear life until this year, when most hedge fund strategies have become correlated with each other and with underlying asset classes. Significant losses seen in hedge funds this year have been magnified by the fund's

leverage and the problem has been exacerbated by rising leverage as investors redeem and asset values fall. This caused leverage to reach almost 4:1 during October 2008. However, manager Mark Cachia says the fund is not "stuck". He has made getting leverage under control his main priority, and has been redeeming fund holdings to achieve this. There have been redemptions from the Cedar Fund ($2.7m came out at the end of September), as for most funds of hedge funds. Based on notices given, a further $6m will come out by the year-end. However, Cachia's sales of funds held in the portfolio more than cover this and he estimates they will bring leverage back down to between 1.2-2x equity, depending on gates imposed and redemption suspensions by funds held. Cachia reports that the Cedar Fund's prospectus allows the manager to gate or suspend redemptions. He neither wants nor expects to exercise this. Debt provided for leverage is contractually secure for a further year (although the margin over Libor was increased from 90bps to 120bps during the third quarter) and Erste Bank maintains its commitment to keeping its $500m invested in the Alternative Investment Group's funds. COMAS GLOBAL ALTERNATIVES ENHANCED FUND, A COMAS GLOBAL ALTERNATIVES FUND, A COMAS ELINAS FUND, A COMAS ASIA GROWTH FUND, A COMAS STRATEGY FUND, A COMAS GLOBAL OPPORTUNITIES FUND A The Comas Global Alternatives Enhanced Fund has fared well compared with other leveraged FOHFs and is down only 18.5% over the year to end-september 2008. Leverage is normally about twice equity in the underlying Comas Global Alternatives Fund (-8.6% over year to end- September). However, the latter held about 21% cash at the end of September 2008, effectively diluting some of the leverage in the enhanced product and providing a useful cushion to unexpected redemptions. Commerzbank's alternatives team has reduced exposure to more creditsensitive funds and also preemptively sold some funds where gates were expected to be imposed. Elsewhere there were both positive and negative surprises. Comas ELinAS Fund and Comas Asia Growth Fund each held up relatively well. Comas ELinAS (Equity Linked Alternative Strategies) Fund was down only 1.7% in September and is down 6.6% over 2008 to date. That compares favourably with other equity-based FOHFs and manager Richard Blake attributes this to its inherent long volatility bias (a number of the funds use derivatives to benefit from volatility) and having an allocation to global macro and systematic trading. Comas Asia Growth Fund was down 13.2% over the year to end-september, comparing well with most other funds of Asian hedge funds, which were typically down over 20%. Comas Strategy Fund was down 13.7% to end-september 2008, surprising on the negative side, mainly due to significant allocations to fixed income credit arbitrage and convertible arbitrage. Comas Global Opportunities Fund was one of the few FOHFs in positive territory at the mid-year stage. It slipped to down 4.0% over the year to end-september after some of its funds with net long exposure to commodities suffered in the sell-off from the beginning of July. GAM TRADING II, AA GAM DIVERSITY, AAA GAM MULTI-EMERGING MARKETS, AA GAM Trading II is one of only two FOHFs we have found that are still up in 2008 to date (+2.4% to end- September). As the name implies, it is invested primarily in commodity trading agencies (CTAs) and global macro funds. CTAs, sometimes referred to as managed futures funds, are one of three sub-strategies that are up in 2008 to date, the other two being asset-based lending (a specialised and illiquid strategy) and short-biased strategies (which FOHFs have only small allocations to as a hedge). However, the fund had its worst month of the year in September (-2.8%) as unexpected moves in the markets caused managers' positions to be stopped out, forcing them subsequently to reduce risk and become more tactical. GAM Diversity and GAM Multi- Emerging Markets returned -10.8% and -16.6% respectively, down slightly less than their multi-strategy and emerging markets FOHF peers. Head of the GAM multi-manager team David Smith reports that GAM Diversity is positioned for volatility remaining high in financial markets and for equities, in particular, remaining difficult in the short term. In the medium term, his outlook for equities is also negative. JUPITER MERLIN ABSOLUTE RETURN PORTFOLIO LIMITED, AA The fund was down 7.0% over the year to end-september 2008, which is one of the better performances within the funds of global equity hedge funds area (the range has been -6.6% to - 26.4%). While the third quarter was tough for the fund in absolute terms, losses were limited by the team's success in getting the underlying exposures down (gross long was 56.8% and net long was 14.9% at end- September) and robust performances from the Framlington Absolute Return UK Fund and the Jupiter Financials Hedge Fund. Looking forward, the Jupiter multimanager team expects performance to pick up once volatility has subsided and fundamentals begin to reassert themselves. That begs the question of when volatility will subside, but the team believes that, by historical declines and periods of extreme volatility, the current bear market is long in the tooth. The team is also encouraged by receding inflation and central bank interest rate cuts. DGC PENDULUM LTD, AAA HAUSSMANN HOLDINGS NV, AAA LYNX SELECTION HOLDINGS LTD EURO, AA Notz Stucki has imposed a gate on redemptions from DGC Pendulum in excess of 15% of NAV. This is consistent with the fund's prospectus that contains a provision for redemptions in excess of 5% of NAV in a single month to be gated. Notz Stucki says this is in response to managers gating. A number of managers held in

the portfolio have already gated, including Black River, HBK, Lydian and Polygon. Many of the managers held in DGC Pendulum are liquidity dependent and have faced significant redemptions from their own funds. Notz Stucki's other two S&P-rated FOHFs - Haussmann Holdings and Lynx Selection - have not gated and there is no intention to do so. They are both invested in liquid hedge funds. Lynx is invested only in European long/short equity hedge funds. Haussmann has a high allocation to equity hedge as well as global macro, which is also relatively liquid. It also has an allocation to daily dealing longonly funds. However, while their portfolios are very liquid because of their bias towards directional strategies, performance has suffered in the current year. Haussmann was down 18.0% over the year to end-september 2008 and Lynx had lost 25.3%. PERMAL Permal has recently changed the notice period on its funds from 20 days to 95 (in line with provisions contained in its fund prosectuses). This follows a sudden increase in redemptions during October and some of the banks that provide the funds' credit line giving notice of their intention to withdraw. The change in notice period has been made indefinitely but Permal will review the situation monthly, taking account of net inflows/outflows, progress on restoring credit lines and general market conditions. RMF FOUR SEASONS STRATEGIES, AA RMF Four Seasons Strategies has held up relatively well against other multistrategy FOHFs, returning -8.7% over the year to end-september 2008. The fund's allocation to managed futures, which recently increased from 11% to 13%, helped performance until July, when some of the commoditiesfocused managers gave back most of their gains from earlier in the year. Reto Grau, head of portfolio management at RMF, reports there was some pressure from clients a year ago to reduce the fund's allocation to managed futures. However, RMF believes diversification is an important risk control tool and managed futures provide useful insurance in the current volatile and illiquid environment. Grau says gating experience among managers held in the fund depends on style. There have been no problems across its equity hedge fund managers. On the other hand, relative value and some of the sub-strategies within event driven have been difficult. The best liquidity has been in the fund's managed accounts. Of the fund's 200 holdings, just over 50 are managed accounts. Grau would like to see this increase to around 100 and would particularly like to get more relative value and event-driven managers to provide managed accounts for the increased liquidity and transparency. THETA MULTISTAR LOW VOLATILITY FUND, A THETA MULTISTAR MEDIUM VOLATILITY FUND, A Theta Multistar Low Volatility Fund and Theta Multistar Medium Volatility Fund have returned -7.2% and -12.7% over the year to end-september 2008. Until the middle of the year, the Low Volatility Fund showed a positive return, reflecting its defensive portfolio positioning. However, the team reports that although it had anticipated the credit bubble bursting, it had not fully appreciated the extent of it. Lowvolatility strategies were hit particularly hard in September (the fund lost 3.8%), perversely as a result of their built-in hedges. Hedges did not work as expected during September because of forced selling and restrictions on shorting financials. Looking forward, the team at Theta believes the current market environment offers outstanding opportunities for those who are able to stay or step in at this point. However, in the short term the team agrees with many of the managers held in the two portfolios, who believe we have not yet seen the end of forced selling in the markets. TURNSTONE EUROPEAN FUND, A Turnstone European Fund was down 6.2% over the year to end-september, which is the best we have seen among funds limited to investing in European equity hedge funds - one of the more difficult strategies in the current year. Turnstone has done a relatively good job of preserving capital for investors because of robust results from four of the fund's top five holdings: Lansdowne UK Equity, Cazenove European Equity, BlackRock UK Emerging Companies and Horseman European Select. However, the portfolio's fifth-largest holding, Marshall Wace Core Fund, has been disappointing throughout this year and a 4.0% holding in Gradient hurt during September. Marshall Wace's broker sentiment-driven investment approach has not worked in current market conditions. In particular it has lost money on its banking and resources positions. Manager Amanda McCracken started redeeming from the fund in the first quarter and her final redemption order will take out the rest in the fourth quarter of 2008. Horseman is a new holding. McCracken bought it earlier this year because, unlike many European equity hedge fund managers, Steven Roberts is happy to go net short. According to McCracken, he has managed Horseman European Select with a 40% net short position for most of this year. Further down the list of holdings, McCracken has recently reduced Threadneedle Crescendo, Cotton Hall, Gradient and Maga Smaller Companies. Turnstone has found a replacement for John Livingstone, who managed its fund of Asian equity hedge funds. Aleem Siddiqui has been a hedge fund analyst specialising in Asian equity hedge at Asset Alliance and is expected to join Turnstone at the beginning of 2009. He will initially provide the day-to-day research and recommendations of Asian equity hedge funds, with McCracken taking the portfolio decisions for the Asian fund as well as Turnstone European. ANALYST RANDAL GOLDSMITH

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