Convertible Arbitrage

be long/short equity, they might also have exposure to merger arbitrage or convertible arbitrage . So, that's good place to start. Again, we do this just to make sure you have exposure to some different types of alternative strategies. Then when we build that portfolio we are also mindful of the overall risk-and-return properties of this strategy. So, again, you want to make sure that's consistent with what you're trying to achieve. So, try to look at what that potential portfolio would have in terms of volatility, downside, downside risk, and beta relative to the broad market. Kapoor: Do you guys want to add anything to that? Papagiannis: I think it's pretty complicated to look at these strategies and to allocate to them. So, I think if you're pretty novice, I would recommend going to an advisor. If you don't feel that you are a novice, if you think that you are more advanced, I think a good way to start is maybe to pick three strategies and whatever you feel like your allocation is that you are going to start with--let's say you are going to start with 15%--I would pick three funds. I would pick a long/short equity, I would pick a managed futures, and I would pick market-neutral or an arbitrage-type fund. And I would just equally divide my allocation of 15% to three funds. Just make it simple. Strauts: I agree with that. Kapoor: There is a good question here also just about fees and how should people think about fees when it comes to these funds because they are certainly higher than what you are used to in a traditional actively managed sort of strategy. So, what's acceptable and what's not acceptable in your minds? Harding: You are correct, and if you look at the alternative mutual funds available, they are definitely going to sport higher expense ratios. I would say 2% and under is kind of a good benchmark to use. I also think it's important to focus on fees in some of those areas that are maybe less volatile, more conservative. We have been talking lot about merger arbitrage, but that's a strategy that is more conservative in nature. The same goes for a market-neutral strategy. Because of that they're going to have less potential for very high return. So you don't really want to spend 2%-3% on a strategy like that just because those fees are going to eat too much into the return potential, especially in the mutual fund universe, where these managers aren't employing the leverage. Hedge fund managers can get away with a conservative strategy like merger arbitrage because they lever it up, but many of the mutual funds don't do that. So you want to be particularly careful on fees within market-neutral and other conservative strategies. Kapoor: Are ETFs cheaper in this space in general? Strauts: Alternative ETFs are more expensive than most of the ETFs we look at. Now, the typical stock and bond ETFs, you can find them for 10-20 basis points. In the ETF space, alternatives are going to be more like 60-100 basis points, which is still a lot lower than 2% threshold actually in mutual funds. So if you're comparing an ETF versus a mutual fund, the ETF is going to be little bit cheaper, but it may not be an active strategy. It may be more of an index approach to alternatives, so can you kind of weigh the pros and cons there. Kapoor: We're going to start taking questions from our in-house audience as well, so if you have a question, raise your hand. I'm going to ask one more quick question, but the mics will start coming to you in the meantime. A quick follow-up to that last answer from all of you: What about from a tax perspective, how should people be thinking about some of the strategies? Should they be in tax-deferred accounts or taxable accounts? Harding: I think it depends on the nature of the strategy and the actual investment. So, I think like many investors would evaluate their equity funds and other types of funds for their tax efficiency, I think you also have to do the same thing. There are some funds that are going to be less tax-efficient. If a lot of the return comes from income or comes from short positions, which gains on shorts are taxed as ordinary income, it will depend on the particular strategy and how it's managed. There are other funds in this space that have done a better job in terms of managing the tax implications. Before Nadia had mentioned covered-call writing strategies: the Gateway fund for example has been pretty good at being fairly tax-efficient in this space as well. So it's something you definitely want to look at the underlying strategy. Papagiannis: That's pretty rare. Kapoor: Would you say use a tax-deferred account in general? Harding: For the most part probably, but again personally in my personal portfolio, I do own some alternative strategies, and it's a taxable account. Again I think there are some that do a little bit better job of that. Strauts: I would just add is that in the ETF space a lot of the ETF alternatives are actually ETNs, and ETNs have the key advantage in that they distribute no income. They don't need to distribute income, and so you get very tax-efficient treatment. So you can own them in a taxable account and even if the strategy is high turnover, you don't experience that turnover through distributions or capital gains; you're only going to pay taxes when you sell the fund. Kapoor: Let's take our first question from the in-house audience. Speaker 1: I was wondering are REITs considered alternative strategies? I am also asking a question about Annaly Capital Management, which has gotten a lot of press lately, and I know Morningstar followed it some years ago, but then stopped. And I was wondering what your position on that is? Kapoor: So I am going to let you take that one, Tim. The question is really whether REITs are considered an alternative investment class? There is also a question about Annaly Capital Management. I am not sure if any of you are familiar with it, but if anyone is, you can comment on that, as well. Strauts: As far as the real estate aspect, I think real estate was a better diversifier before it was added to the S&P 500. So I forget what year it was added, but it was little over 10 years ago. It was added to the S&P 500, and the correlations have risen since then, because if you own the S&P 500, you own REITs. So it still is a diversifier because you own property, but it's is not as good a diversifier. As far as Annaly Capital Management, I can't speak exactly about it, but it's a mortgage fund. I would say it pays a very high-income, usually over 10%, but I don't know what it's paying now. So it's usually very attractive to people looking for yield. They see this over-10% dividend. The problem with it is that the dividend gets cut a lot when the volatility increases, especially in the mortgage market. There is a lot of uncertainty there. So you can't count on that dividend. So it's going to be a very volatile security. Kapoor: The next question, please? Speaker 2: I am just curious from an information-resource basis, there is nothing more frustrating than to say you want to diversify your portfolios, and then all of a sudden you are getting a K-1, which complicates your income taxes because you weren't anticipating a K-1 rather than getting a temporary thing. And the other side of it, say you buy a commodities fund because you have looked at what the noncorrelations are between the commodity fund numbers. And then you buy a commodity fund, but it doesn't really track the commodity because you have the roll issue, which you talked about. So I understand what all the caveats are, but I do not know how to look at an individual investment and to know whether it has that risk or it doesn't have that risk. Are you providing that information within Morningstar? Kapoor: So the question really is around how you can protect yourself from some of the caveats that a lot of you have brought here today. So obviously I'd like to hear your views on that, as well. Morningstar.com is a great place to start, but what else do you use as resources. Harding: Well I think in the case of the commodity investments and whether they track or not I mean you can look at the returns generated by a particular fund relative to the commodity index it's meant to track and see if it has a done a reasonable job of delivering that return stream or not. I think that's kind of the easy thing. Then in terms of other sources of information besides the returns and the risk statistics we have on Morningstar.com, I would suggest the Analyst Reports, and I think that would maybe get into some of the nuances involved in whether you are going to be prone to a K-1 with a particular investment or if there are other kinds of tax things to think about. A lot of those issues tend to be addressed in the Analyst Reports that are written. Strauts: I would just say that on Morningstar.com, in the operations tab, if it's a limited partnership, it's likely buying futures contracts, so it's likely going to give you K-1s. But again with our Analyst Reports, if we cover it, we'd also tell you that. Then as far as the tracking issue, a lot of people had concerns with some of the ETF commodity products where, again, I mentioned natural gas. For people who bought say regular a natural gas fund, there was a year I think it was 2008, 2009, where natural gas was actually positive for the year. But the natural gas fund loss like 30% to 40%, and it's because of this roll issue. So, what they've done in the space is that new products have come out that try to mitigate the roll issue with the contango. So one fund I like that's in the broad commodity space is USCI, United States Commodity Index, and it actually tries to mitigate the contango by not buying just the front-month contract, but buying contracts further out in the curve, so it doesn't have to roll as much. And it also looks for commodities that are in backwardation, which means that when they roll, they actually make money versus contango, when you lose money when you roll. Kapoor: What are some of those commodities? Strauts: The commodities that are in backwardation change all the time. This fund just dynamically will allocate more money to commodities in backwardation. Speaker 3: I have a question about hedge funds; they used to be regarded as more of a personal one-on-one high investment-type of vehicle. Now you folks actually mentioned hedge funds and talked about them. Could you give a summary of where they stand today? I also want to follow-up on that gentlemen's question, if you buy a hedge fund, do you automatically get the K-1 to complicate your income taxes, and just where do they stand now? Kapoor: So that's a broad question just around hedge funds, and accessibility of hedge funds, and tax situations of hedge funds. So, Nadia, it seems like a good question for you. Maybe you can also sort of address who can invest in the hedge fund? Papagiannis: Sure. So, hedge funds, there are still a lot of them out there. The number of funds that are good that are accessible to smaller investors are few and far between, basically the funds that are good have a ton of money in them already, and they don't need individual investors' money. They only take money from very large institutions, and many of them are closed already. So, first of all, trying to find a hedge fund period is difficult because there is no one source of hedge fund information. Morningstar does have a hedge fund database if you are an accredited investor that you can go and look at. But I mean there are thousands of funds, and it's very difficult to sort through. They don't have to report portfolio holdings and things like that. So finding the hedge fund is the problem number one. Then once you found the hedge fund, finding one that's going to take less than $1 million just in one hedge fund's investment, $1 million. I don't know that you want $1 million of your net worth tied up in just one hedge fund, because not only do you have this investment risk, which is with any investment, but you also have operational risk that the hedge fund manager could just take off with your money or they could blow it up because they are taking a lot of leverage and a lot of illiquidity bets. Kapoor: Are hedge funds of funds an option? Papagiannis: Hedge funds of funds are an option. The problem there is fees, layers and layers of fees. If you add them up, it's probably close to 6% in fees. Kapoor: Almost Cook County sales tax. Papagiannis: The ability of you to be able to find a good hedge fund manager after fees that you can afford and that you can have a decent allocation to is very unlikely for the 99% of us. So, I would say pretty much stay away. Then the tax consequences, they're limited partnership, so it flows through. So whatever they trade you get the tax characteristics of that. So if they're trading futures contracts, that's actually a tax-efficient characteristic at 60% long-term capital gains. But you do get the K-1. A lot of advisors I've talked to say sometimes the K-1 is a problem, and sometimes it's not a problem at all. So maybe you get them one month later than you have to do your taxes. Some advisors complain about six months later. I would think that for funds of funds you get them later because not only do they have to get everything from all of their feeder funds, they then they have to send it to you. So it's probably more of an issue with funds of funds, but some people consider that an issue, and some people don't. In general if you are an individual investor I would stay away from hedge funds and other illiquid things like nontraded REITs and things like that. Speaker 4: As alternative investments become more popular, won't there be more and more correlation? Kapoor: The question is around correlation. Speaker 4: Correlation with the stock market; won't they become a crowded train? Kapoor: So I think, Bill, you tried to address this earlier saying that it tends to be the case that the correlation peaks when there tends to be very market-moving types of event. But what about over longer-term periods? Harding: I think if we looked at various hedge fund indexes that have been around for quite some time, we can look at rolling correlations over time. I think while they may spike in times of crisis, in general over a longer period time they haven't really risen too extensively. And you make a point that if money is chasing into these alternatives, I think it's more about will the opportunities still be there rather than will the correlations increase? Because a lot of these strategies are using arbitrage-related strategies. It is really idiosyncratic risk, meaning its risk that's not tied to market movements or it shouldn't be. Merger arbitrage, it's really about that particular event and the possibility or probability of that event unfolding. So it's not as much as correlations; I think as more money piles into these different strategies at times you may have less opportunities, maybe spreads compress a little bit. So that will lead to maybe a little bit lower return potential. Sometimes we've seen managers in certain areas like convertible arbitrage . They are going to be influenced by the overall supply-and-demand dynamics. The convertibles market has had little supplies, so some managers have

and that provides a lot of diversification benefits. But we also like convertible arbitrage strategies. We like long-short strategies--although oftentimes investors forget that these still have a great deal of equity exposure, so they are not

protection. And that was because all the deleverage, you know, of the convertible arbitrage and the hedge funds and that type of thing going on. But if you look at the two years, '08 and '09

the most basic core strategy to the Diversified Arbitrage Fund, which is convertible arbitrage – it's far from the only strategy, that's why we call it Diversified Arb, but convertible is probably the biggest amongst equals,