ALTERNATIVE INVESTMENT SOLUTIONS

hedge fund ELEMENTS Performance Reporting

Hedge Fund managers wisely pay critical attention to reporting the performance of their funds. Taking a worse case scenario mentality such as having to defend your marketing materials in court is the most prudent approach. For this reason, ALPS suggests using best industry practices combined with a thorough vetting of materials by the Fund’s legal counsel prior to sharing with prospects. This element will cover: §§

the best industry practice of performance reporting and how that relates to GIPS and AIMR

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the components of the ALPS performance report

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typical statistics used on performance reports

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common questions and Disclosures

What are the best industry practices with regard to performance reporting and how do GIPS (Global Investment Performance Standards) and AIMR (Association of Investment Management & Research) apply to a Hedge Fund? Hedge funds are often asked if their performance numbers are AIMR or GIPS compliant. AIMR PPS (Performance Presentation Standards) was conceived in 1993 and evolved during the 1990s, with an international version – GIPS – appearing in 1999. As of 2006, a newly updated version of GIPS superseded and replaced AIMR-PPS. The CFA Institute’s GIPS Executive Committee, the governing body for the Global Investment Performance Standards, published the “Guidance Statement on Alternative Investment Strategies and Structures” October 1, 2012. Much of the documentation is oriented to the managed account business, specifically providing rules to deal with the creation of composite returns among many accounts with varying starting and ending dates, differing asset sizes, and each with cash flows determined by the underlying investors. As well as addressing computation standards, GIPS provides guidance on relevant qualitative disclosure. GIPS is divided into 7 sections: 1)  Input Data 2) Calculation Methodology 3) Composite Construction 4) Disclosures 5) Presentation and Reporting 6) Real Estate 7) Private Equity

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Performance Reporting continued For fund administration purposes, we believe that Input Data and Calculation Methodology are the most relevant sections, addressing such things as: §§

Trade date accounting

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Valuation

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Accruals of income and expense

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Time-weighted returns

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A total return approach – net of fees and expenses

While the Disclosure and Presentation and Reporting Sections primarily address firm-level (not fund-level) disclosures and composites, there are some relevant requirements and recommendations that would apply to presentations of results, at least as calculated by ALPS: §§

Display performance since inception or at least five years

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Prohibition of annualizing returns of less than 12 months

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Use of total return benchmarks

Compared to a composite, performance is actually much more straightforward with a fund in that it is a single entity, with discreet entry and exit periods, a single investment objective, and legal documents that specify the exact method for allocating income to each participant. Accordingly, a hedge fund is not a composite, but a single portfolio with individualized fee arrangements. It is unnecessary to aggregate the participants’ returns because the return for an ordinary, fee-paying investor is readily available. At ALPS, we present the fund return as the investment results for “a single contribution at the inception of the Fund with no subsequent additions or withdrawals.” Managers should note that aggregating participant returns to determine a fund return, on the other hand, would be less accurate. For example, some investors may pay no incentive compensation during a period due to waivers or being in a position of making up prior period losses, while others will. Aggregating those returns would be misleading and, at best, inherently flawed because no one person could have received the aggregate return if there are multiple openings or differing fee rates. At worst, it could be considered deceptive because including non-fee payers (such as the manager) in the composite would be known in advance to overstate the return possible to an unaffiliated investor.

So, “Is my performance GIPS compliant?” The short answer is that ALPS methods conform to the relevant “Input Data – Requirements” and “Calculation Methodology – Requirements” of GIPS (Sections 1.A & 2.A). A longer answer requires us to point out that ALPS cannot claim to provide a “GIPS compliant” report, since compliance is something that is determined at the level of the management firm as a whole. In addition to the issues of proper disclosure for a manager’s

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Performance Reporting continued other funds or separate accounts and any possible “composites,” there are qualitative disclosures both recommended and required. For example, a manager must disclose sub-advisors and significant derivatives usage, plus “all significant events that would help a prospective client interpret the performance record.” Accordingly, only the manager can determine GIPS compliance. In responding to questions about GIPS and your fund, ALPS suggests that managers note the following: §§

the fund has governing documents that determine the accounting process.

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Your fund’s accounting is in accordance with Generally Accepted Accounting Principals (with the possible exception that you may be spreading formation costs over several years in the interest of fairness).

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Fund results are determined by ALPS, an experienced and highly regarded independent third-party administrator.

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ALPS methodology conforms to the relevant “Input Data – Requirements” and “Calculation Methodology – Requirements” sections of GIPS.

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The fund is audited annually

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GIPS is intended to create a single number that fairly represents the performance of a composite of accounts, while the numbers provided by ALPS are actual fund results, in the form of “the investment results of a single contribution at the inception of the Fund with no subsequent additions or withdrawals.”

The Performance Report provided by ALPS Upon request, ALPS can prepare a performance report (commonly referred to as our “Perf Rep”) containing graphical and statistical measures that managers may find interesting or useful. Note that there are a number of rules, regulations, and interpretations that address the proper disclosure of performance information to current and prospective investors. Accordingly, if Perf Reps are to be used for marketing or investor communications, it is a must to contact your attorney to determine if a Perf Rep is appropriate for your fund and have them review and draft desired changes to the boilerplate disclosures and notes. All fund sales materials should be reviewed by qualified persons to assess compliance with the anti-fraud provisions of the Investment Advisers Act of 1940 plus any state or other rules that may apply. The Perf Rep consists of historical data, a comparative index, statistics, charts and disclosures.

Historical Data determines fund performance. Fund “official” performance is that of a hypothetical unrestricted (with regard to new issues) participant who invested at inception, has made no capital additions or withdrawals, and who is charged fees and incentive compensation as set forth in the offering documents, without fee reductions or waivers. Monthly results are reported on a “contingent net basis” – as if the incentive compensation, if any, had been charged – even though the actual incentive compensation may not be allocated or paid until a later date. With the hypothetical investor methodology utilized by ALPS, waived or reduced fees will not increase performance. The tracking account is still charged manager compensation as set forth in the offering documents. The reasoning is, since prospective investors will presumably pay full fees, it could be considered deceptive to show a track record without them. When more than one option is available in the fund documents, ALPS suggests showing the performance of the most conservative structure.

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Performance Reporting continued Sometimes funds restructure, documents are amended and fee rates change. ALPS suggests asking legal counsel to prepare a note explaining the change (such as: “This report reflects a management fee rate change from 1% to 2% as of January 1, 2008. Results prior to that date reflect the earlier fee rate.”). For some funds with shorter track records, ALPS may be able to go back and adjust the tracking account to the new rate so that the Perf Rep reflects current fees over the entire period. While this may be preferable from a disclosure perspective, it will change prior official numbers, which may not be desirable. You should consult your attorney for guidance. The minimum data required to create a Perf Rep is 3 months. Until there is a full year, all displays involving annualized numbers are suppressed. It is important to note that even the non-suppressed statistics are not particularly useful until the number of data points becomes significant. The usual starting point for data is the Fund’s inception date. If there is a desire to include pre-fund investment results or to start the Perf Rep at some date after actual fund inception, the fund manager needs to consult legal counsel to address the potential legal issues (if it were not clearly stated that the displayed track record was not actually within the fund or excluded an existing prior track record, there would seem to be potential legal issues regarding disclosure.) If approved, counsel needs to draft appropriate legal notes for inclusion on the Perf Rep. How about the use quarterly instead of monthly data? There are several practical reasons. One is that investors today nearly always ask for monthly data if they are aware that the fund is valued monthly. Also, the more data points, the more valid the statistics – 5 years of quarterly numbers is only 20 data points. Accordingly, all ALPS Perf Reps are formatted for monthly data.

A Comparative Index is standard in most performance reporting. ALPS keeps a database of most common equity indexes, plus a number of debt indexes as well. Our principal requirement is that the index be published and publicly available. Not only does that facilitate our independent acquisition of the data, but it eliminates obscure or private indexes that investors can’t find or verify themselves. There are two major considerations in an index choice: 1. The legal question relates to what inferences may exist in the choice of an index. Would a comparison solely to T-bills and bonds imply that the fund has a similar risk profile? In an always hedged long-short equity fund, does the use of the S&P 500 imply something that could be misleading? What is the relevance of a small cap benchmark for a large cap fund? These are questions that you should discuss with your attorney. For added context about this issue, note the following disclaimer that is suggested in the notes for a Perf Rep: “Market indexes are included in this report only for comparative purposes and as context reflecting general market results. The Fund does not seek to replicate the composition, or mirror the performance or volatility, of any such index, and can be expected to have investments that differ substantially from the securities or other instruments included in any such index. Accordingly, no representation is made that the performance or volatility of the Fund will track or otherwise reflect any particular index.” 2. Investors use statistical comparisons to evaluate investments. Reporting a beta or correlation versus an obscure index may not be of much value. On the other hand, comparing a market-neutral portfolio to the S&P 500 is probably valuable because the

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Performance Reporting continued statistics help measure the extent to which the fund is affected by the market. In other words, if the intent is to be different from the market, it’s a good idea to show what the market did over the same time period. We suggest that most funds compare against the S&P 500 with dividends reinvested. Regardless of whether the S&P 500 is what you consider your “benchmark,” it is a universal yardstick for statistical measurements, and most investors will want to understand your fund’s statistical relationships to the “market” as a whole. For a second index, funds which invest in the broad market often include the Russell 2000 or NASDAQ, and some funds may choose other indices which they view as “benchmarks.” Keep in mind that the choice of an index is semi-permanent. When managers decide to change a benchmark, it can raise questions from investors. Accordingly, it is important to predict what you will want as index comparisons two years from now and to get the choices approved by your attorney. While ALPS provides boilerplate notes on Perf Reps that attempt to disclaim any performance inferences due to index choice, you should have your attorney review and approve that section as well. Blended benchmarks are discouraged due to the regulatory concerns mentioned in point #1 of the immediately preceding question. When a manager sculpts a custom index, the promissory implications of a benchmark become even more problematic, as we feel there is a clear suggestion that the blended benchmark was created in the image of the fund. Accordingly, the statement that “no representation is made that the performance or volatility of the Fund will track or otherwise reflect any particular index” would ring somewhat hollow and there would be possible added liability due to failure to match the risk and return characteristics of the blend. An index of hedge funds or fund-of-funds, while sounding appealing has it’s own issues. In addition to survivorship bias, the low volatility of these indexes makes them unsuitable for comparisons. Unlike an unmanaged equity index, each hedge fund monthly result reflects a unique set of market and security exposures. The average of these will usually display a fraction of the volatility of the majority of hedge funds separately. An index, without dividends is also discouraged. The GIPS (formerly AIMR) guidelines plus SEC Rule 205-1 both characterize benchmarks as total-return indexes. Accordingly, the index with reinvested dividends should be used if publicly available.

Statistics The statistics ALPS Perf Rep typically display are: §§

Return metrics: compounded annual return, compounded monthly return, greatest monthly return, average gain and percent of positive months

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Risk measurements: standard deviation, downside deviation, Sharpe ratio, Sortino ratios, average monthly loss, greatest monthly loss and maximum drawdown

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Regression: alpha, annualized alpha, beta, R-squared and correlation

The ALPS Perf Rep is highly automated with a few limited choices for customization. While this might seem rigid, the automation, especially as it relates to statistics, is preferable and safer to produce than one made by manual update. Additionally the reader will find value in knowing that the report was independently produced by a reputable service provider. Our feeling is that, once added, statistics should be considered more or less permanent. Changing statistical comparisons (or benchmarks – see below) can lead the investor to believe it is biased. The statistics we’ve chosen to provide are industry standard and provide specific information to the reader.

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Performance Reporting continued Sharpe and Sortino Ratios are measures that seek to quantify the relationship between risk and return. Generally speaking, they are determined by dividing a measure of “excess” return by a measure of risk. The basic idea is that a 20% return can’t be determined to be better than a 15% return without understanding the relative levels of risk. By using Sharpe and Sortino ratios, one can compare differing returns with differing risk characteristics. Higher numbers reflect more favorable risk-adjusted performance. Standard Deviation Standard deviation measures the distribution of returns about the mean. Low standard deviations reflect low variation in monthly results; higher variability is usually interpreted as higher risk. Standard deviations are based on monthly results, and then annualized. Downside Deviation Calculated much like standard deviation, Downside Deviation – DD – is a measure of the volatility of results which are less than the monthly MAR – the “minimum acceptable return.“ DD is an alternative to the standard deviation of all results in a data set, and distinguishes between negative and positive volatility. Downside deviation is accompanied by the assumed MAR in parentheses. Sharpe The Sharpe Ratio is the ratio of “excess return” to volatility. Excess return is defined as the annualized rate of return less the risk-free rate (ALPS tracks 30 day T-bill returns), compounded monthly. The volatility measure is the annualized standard deviation of monthly excess returns. Many people calculate Sharpe Ratios using a short cut: basically, take the annualized return of the fund, subtract the annualized return of the risk free rate, then divide that by standard deviation of the return. ALPS uses the textbook method, which is to subtract the risk free rate from the fund return each month; take that monthly “excess return,” compound it over time; determine the annualized rate of return and divide that by the annualized standard deviation of those excess returns. Because the risk free rate can change over time – and may have a relationship to volatility – the two methods give slightly different results. If you read William Sharpe, you’ll note that “average” returns may be used; although he notes that over longer periods, it is better to compound. One may occasionally see a Sharpe Ratio followed by a percentage in parentheses such as “(0%)” or “(5%).” This is an offshoot of the Sortino Ratio which uses a concept of “minimal acceptable return” (MAR), and where the relevant MAR is expressed this way. However, the Sharpe Ratio is built around a risk-free rate, not an acceptable return, so this particular shortcut might be viewed as intellectually lazy. One might argue that T-bills are not risk free but there is no apparent replacement, so short-term bills are what most Sharpe calculations use. Sortino The Sortino Ratio is a variation of the Sharpe ratio which distinguishes between negative and positive volatility. The idea is that volatility in a managed fund would be expected to be asymmetric, since money-managers attempt to limit losses. Accordingly, the Sortino ratio replaces standard deviation – which penalizes upside and downside volatility equally – with a different measure. The Sortino ratio also uses the concept of an arbitrary “minimal acceptable return” – MAR – instead of the risk-free rate. The measure of negative volatility, or “downside deviation,” is calculated on results which are below the monthly MAR. The Sortino Ratio is the return in excess of the MAR divided by the downside deviation. Sortino Ratios are expressed as a ratio with the assumed MAR in parentheses following. Note that “Downside Deviation” is not the standard deviation of the returns less than the MAR. It has a specific calculation method which can be found at the Sortino web site.

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Performance Reporting continued Maximum Drawdown This is the measure of the decline from a historical peak of cumulative returns. Volatility Volatility is a measure for variation of rates of return over time derived from time series of past results. Upside and Downside Volatility refer to a distribution’s percentage of total variance from returns above the mean (upside) or below the mean (downside). Regression Statistics Regression models are used to predict one variable based on the observations of another variable. For our purposes, the independent variable is an index return and the dependent variable is the performance of the fund. Visually, the monthly results of each are plotted on a “scatter graph,” each point representing an “x” value equal to the index return and a “y” value equal to the fund return for the same month. A “least-squares” linear regression line is calculated as a “best fit” to represent the data points. Note that some more complex calculation methods use the fund’s return in excess of T-bills as the dependent variable. ALPS uses the fund’s absolute return. Correlation Correlation (“R”) is a measure of the degree of linear relationship between two variables, in this case, the relationship between the monthly returns of the fund and an index. 1.00 would indicate perfect positive correlation; 0.00, no correlation; and –1.00, perfect negative correlation. R-Squared The square of correlation serves as an indication of the “fit” of the data points to the regression line. An R-squared of 1.00 would indicate that each data point was located on the regression line; in other words, a perfect fit. An R-squared near zero would indicate that the regression line is essentially meaningless – data points appear random and do not strongly support the regression line. A low R-squared is generally appealing when seeking an investment which acts independently of the market index. Alpha If one pictures the linear regression line, alpha is equal to the “y-intercept” – the “y” value where the regression line crosses the “y” axis. This is the expected return when the index return – the “x” value – is zero. In other words, it is the intrinsic return of the fund in the absence of market influence. As alpha is calculated on monthly data, an annualized figure is also provided. Beta The slope of the regression line is beta. A positive beta indicates that fund returns have been better when the index return is better. A negative beta would indicate better results in declining markets. Beta is a measure of a fund’s susceptibility to the extent and direction of market volatility. This material has been prepared by ALPS for general informational purposes only. It does not constitute tax, legal or investment advice, and is presented without any warranty as to its accuracy or completeness or whether it reflects the most current developments. ALPS does not provide tax, legal or investment advice. You are urged to consult your own tax, legal and investment advisors.

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Performance Reporting continued Charts and Graphs ALPS Perf Rep may include a plot of cumulative return, a scatter gram of risk versus return and/or a monthly return distribution bar graph. The cumulative performance graphs showing “cumulative return” can display in percent or “growth of $1000.” While cumulative percent return graphs may be appropriate in the first few years of a fund’s life, we recommend shifting to “growth of $1000” once returns of the fund and/or benchmarks approach 100%. The reason is that the “growth of $1000” graphs permit logarithmic scales. If a fund is already up 100% ($1000 has grown to $2000), a 10% return is equal to $200, which translates to 120% cumulative. On a linear scale, that change will be twice the size of a similar return at fund inception. Consequently, the apparent volatility becomes misleading. Log scales are not used with percent returns because the start point is zero and the possibility of negative numbers.

Disclosures The notes and disclosures on the Perf Rep are customizable, although if fund counsel suggests substantially increasing the volume of disclaimers, it may run on to a second page. The ALPS “Perf Rep” comes with a set of standard “boilerplate” disclosures that we’ve developed over the years. That doesn’t necessarily mean that they are appropriate for your fund. Note that there are a number of rules, regulations, and interpretations that address the proper disclosure of performance information to current and prospective investors. Accordingly, if Perf Reps are to be used for marketing or investor communications, you must contact your attorney to determine if a Perf Rep is appropriate for your fund and to review and draft desired changes to the boilerplate disclosures and notes. All fund sales materials should be reviewed by qualified persons to assess compliance with the anti-fraud provisions of the Investment Advisers Act of 1940 plus any state or other rules that may apply. The following are samples of ALPS boilerplate disclosures: Purpose

Content

Performance Disclosures

All returns are purely historical, are no indication of future performance, and are subject to adjustment. Changes in markets, interest and exchange rates, economic and/or political conditions and other factors may influence the future performance of the Fund. The Fund may also from time to time change its investment strategies and objectives and allocate Fund assets differently than in prior periods.

Risk Disclosure

An investment in the Fund involves significant risk, including the potential risk of loss of a substantial portion (or all) of the amount invested. The offering documents relating to the Fund contain brief descriptions of certain of the risks associated with investing in the Fund.

Confidentiality/ Advice Disclosure

This information is strictly confidential and may not be reproduced or redistributed in whole or in part nor may its contents be disclosed to any other person under any circumstances. This information is not intended to constitute legal, tax, accounting or investment advice. Prospective investors should consult their own advisors about such matters.

ALPS boilerplate disclosures continued on page 9.

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Performance Reporting continued

ALPS boilerplate disclosures continued from page 8. Purpose

Content

Document Limitation Disclosure

This document is informational in nature and for use only by sophisticated investors who meet certain minimum financial requirements. No representation is made that this information is accurate or complete and it should not be relied upon as such. The Fund’s interests may not be eligible for sale in some states or countries, or suitable for all types of investors. Additional information will be provided upon request.

Index Disclosure

Market indexes are included in this report only for comparative purposes and as context reflecting genera market results. The Fund does not seek to replicate the composition, or mirror the performance or volatility, of any such index, and can be expected to have investments that differ substantially from the securities or other instruments included in any such index. Accordingly, no representation is made that the performance or volatility of the Fund will track or otherwise reflect any particular index.

Performance Reports for Pre-ALPS Numbers Disclosure

Results for the period prior to fund inception on 1/1/2005 are those of a general partner managed account, net of estimated manager compensation, but with no provision for third- party expenses.

Start date later than inception Disclosure

Results on this report commenced on 1/1/2005. Results from fund inception (1/1/2004) are available from the general partner.

This material has been prepared by ALPS for general informational purposes only. It does not constitute tax, legal or investment advice, and is presented without any warranty as to its accuracy or completeness or whether it reflects the most current developments. ALPS does not provide tax, legal or investment advice. You are urged to consult your own tax, legal and investment advisors.

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