1. Reducing Risk in the Hedge Fund Portfolio with CTA’s By: Thomas F. Basso CEO, Trendstat Capital Management, Inc. 6991 E. Camelback Rd. #D210 Scottsdale, AZ 85251 Email: tom@trendstat. com Telephone: 602 - 970 - 3600 December, 1998

2. The last half of 1998 threw many hedge funds some rare, but dramatic moves across many markets. A number of hedge funds and fund of funds were hurt by the moves. I keep hearing from clients that they feel comf ortable including hedge funds in their portfolio, but not CTA’s. Since I would call myself both a hedge fund manager and a CTA, this anti - CTA bias has been mystifying. This study looks at why it makes good sense to blend in some CTA’s to a traditional he dge fund world. I first obtained from MAR - Hedge the median benchmarks for the various sectors they track in the hedge fund world. I added to my database the S&P 500 Composite Index and MAR’s CTA Index known as the Trading Advisor Qualified Index (MAR - TAQ I). That gave me eleven sectors to use for a correlation analysis. Next, I thought about what an investor should look for when diversifying a multiple manager portfolio. Aside from profits, which most segments exhibit over time, the investor needs as mu ch non - correlation as possible in the portfolio. High positive correlation does little to diversify. Strong negative correlating sectors would fight each other, costing the portfolio returns. Only low or non - correlating sectors with decent returns would give the investor the diversification he or she seeks. In Table 1, I broke the correlation pairs down into four groups. If the correlation of the sector pair was over 0.5 or under – 0.5, I showed the results in plain type. These pairs would be poor cand idates to improve diversification. The numbers in just bold type are mildly correlating pairs and would be reasonable choice, but not great. Finally, the number in bold with a box are very low or non - correlating pairs, which should provide the most benef it to the portfolio when looking for true diversification. The CTA group came through with the most boxes. Table 1 – Hedge Fund Sector Correlation Pairs Correlations of various benchmarks from January, 1990 to October, 1998 Diversifying the portfolio over the long-run Global Global Market Market CTA Event Regional Regional Global Market Neutral Neutral Short S&P 500 Index Driven Global Emerging Establishd Macro Neutral Arbitrage Long/Short Sellers Index TAQI Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Event Driven 1.00 0.73 0.61 0.69 0.50 0.67 0.71 0.39 -0.54 0.48 -0.17 Global 1.00 0.72 0.70 0.60 0.58 0.64 0.32 -0.74 0.74 -0.14 Global Regional Emerging 1.00 0.62 0.46 0.52 0.52 0.23 -0.52 0.47 -0.14 Global Regional Established 1.00 0.52 0.55 0.46 0.37 -0.47 0.49 -0.11 Global Macro 1.00 0.46 0.41 0.22 -0.39 0.46 0.21 Market Neutral 1.00 0.79 0.51 -0.41 0.32 -0.19 Market Neutral Arbitrage 1.00 0.38 -0.54 0.44 -0.26 Market Neutral Long/Short 1.00 -0.17 0.32 0.08 Short Sellers 1.00 -0.73 0.23 S&P 500 Index 1.00 -0.06 CTA Index TAQI 1.00 Average monthly return * 12 12.71 11.41 13.05 12.10 14.89 10.42 11.32 10.13 2.86 13.85 13.41 Correlation of >0.50 Reasonable correlation, doesn't help much to diversify the portfolio Correlation of <-0.50 Fairly inversely correlated. Doesn't help much in creating returns, since one group offsets the other group Correlation of 0.5 to 0.25 or -0.25 to -0.50 Mild positive or negative correlation. Okay, but not great for diversification Correlation of <0.25,>-0.25 Non-correlation. The perfect addition to a portfolio to improve long-run results Conclusion: CTA index is the most appropriate diversification for larger portoflios due to consistent non-correlation. Tom Basso, CEO of Trendstat Capital Management, Inc, a Scottsdale, AZ hedge fund manager and CTA Next, I considered how the segments were stress tested during the recent market turmoil from Aug ust to October, 1998. Segments that were highly correlated with losses provided no risk

3. aversion for the portfolio. Segments with a positive return and strongly negative correlation to other pairs would have done the most to minimize the damage. In Tabl e 2, I showed the correlation pairs during the period from August, 1998 to October, 1998. Table 2 – Hedge Fund Sector Correlation Pairs Correlations of various benchmarks from August, 1998 to October, 1998 Minimizing the damage to the portfolio Event Regional Regional Global Market Neutral Neutral Short S&P 500 CTA Index Driven Global Emerging Establishd Macro Neutral Arbitrage Long/Short Sellers Index TAQI Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Return-% Event Driven 1.00 1.00 1.00 1.00 0.43 0.99 0.97 0.04 -1.00 1.00 -0.85 Global 1.00 1.00 1.00 0.45 1.00 0.97 0.07 -1.00 1.00 -0.83 Global Regional Emerging 1.00 1.00 0.43 0.99 0.97 0.05 -1.00 1.00 -0.84 Global Regional Established 1.00 0.44 1.00 0.97 0.06 -1.00 1.00 -0.84 Global Macro 1.00 0.52 0.21 0.92 -0.39 0.48 0.12 Market Neutral 1.00 0.94 0.15 -0.99 1.00 -0.79 Market Neutral Arbitrage 1.00 -0.19 -0.98 0.96 -0.95 Market Neutral Long/Short 1.00 0.00 0.10 0.49 Short Sellers 1.00 -0.99 0.87 S&P 500 Index 1.00 -0.82 CTA Index TAQI 1.00 Average monthly return * 12 -25.80 -31.40 -114.88 -44.60 -15.56 -2.20 -7.28 6.56 35.84 -0.40 32.16 Correlation of >0.50 Poor diversification, added to the losses Correlation of <-0.50 Strong inverse correlation during period, helped minimize damage Correlation of <0.25,>-0.25 Non-correlation. Decent addition to portfolio over short data set Conclusion: CTA index is an excellent diversification for larger portoflios due heavy inverse correlation during volatile period. Tom Basso, CEO of Trendstat Capital Management, Inc, a Scottsdale, AZ hedge fund manager and CTA Again, I used the bold boxes to show where the portfolio would have its best diversification and risk control. T wo sectors came through fairly strong: short - sellers and the CTA’s. The short sellers should be no surprise, since they had the wind at their back with a down stock market. The potential problem with this sector is the negative correlation over the long - run and short run reducing potential portfolio return. CTA’s were able to exploit large moves in debt instruments, stocks and energy prices to create nice profits. In other words, the large movements that created the problem for many hedge funds were the catalyst for large CTA profits. For those looking for an easy way to diversify their risk exposure to various sectors, it would seem prudent to look at the CTA side of the hedge fund industry. Tom Basso is CEO of Trendstat Capital Management, Inc. , a Scottsdale, AZ hedge fund manager and CTA managing over 300 million dollars for clients in a variety of markets. (12/98)