Hedge Funds

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Hedge Funds

• The Indebted Society
• Economics 1813
• Harvard University

Michael Dubilier Dubilier Company Ronald W. Sellers Atlantic Asset Management, LLC
Stamford, Connecticut 203-351-2800 www.atlanticasset.com (research tab) November 22, 2004 Stamford, Connecticut 203-351-2800 www.atlanticasset.com (research tab) November 22, 2004
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Order of Topics

1. What Is A Hedge Fund?
2. Industry Overview
3. Investment Strategies
4. Case 1. Mortgage Derivative Hedge Fund
5. Case 2. Macro Economics Hedge Fund
6. Appendix Web Pages

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I. What is a Hedge Fund?

• Class questions
• How many have heard of hedge funds?
• How many think they know what they are?

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What is a Hedge Fund?

• Formal definition there is none
• Websters Dictionary has hedge between hector
  and hedonism with three definitions
• boundary
• means of protection
• a deliberately ambiguous statement
• Hedge funds have all these characteristics

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What is a Hedge Fund?

• Hedge funds in the U.S. investment
  industrytypical characteristics
• L.P. or L.L.C., or other corporate structure
• Formed onshore or offshore or both
• Unregistered investment vehicle for QPs only
• Both asset based and performance based
• Managers are small special purpose firms
• Operate a single investment strategy for absolute
  total return
• Hedging is used to reduce certain investment
  risks
• Leverage is used to enhance returns

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II. Industry Overview

• 875 billion assets in about 6,000 Hedge Funds

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Industry Overview

• Hedge Fund Asset Growth, Billions

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Industry Overview

• Hedge Fund Net Performance
• January 1998 June 2004

Net Compound Annual Return Standard Deviation
CSFB/Tremont Hedge Fund Index 7.8 7.6
MSCI World 6.2 16.2
SP 500 Index 12.3 15.3
Morningstar Average Equity Mutual Fund 9.8 15.8
LB Aggregate Bond Index 8.1 4.4
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Industry Overview

• Who invests in hedge funds?
• 1992 2002
• Institutions 19 52
• Individuals 81 48

Investors Include High
Net Worth Individuals Endowments Foundations
Family Officers Pension Plan Sponsors
(ERISA) Private Banks Retail Investors
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Industry Overview

• Hedge Fund Regulation
• Typically
• They are exempt from registration under the
  Investment Company act of 1940, and therefore not
  public mutual funds
• They are exempt from registration under the
  Securities Act of 1933, and therefore cannot make
  public offerings
• Their advisors are exempt from registration under
  the Investment Advisors Act of 1940

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Industry Overview

• Exemption from Registration
• Is achieved by
• Have less than 100 investors or sell interests
  only to qualified purchasers (with 5 million
  of investments)
• Do not offer securities publicly no public
  solicitation
• Have 14 clients or fewer hedge fund is one

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Industry Overview

• Investment Advantages
• Removes restrictions and requirements with
  respect to
• Use of leverage and short-selling
• Computation of NAV, the basis for determining
  fees
• Extensive reporting and disclaimer obligations,
  including printed prospectus approved by the SEC
• SEC examiners and fiduciary duties to clients -
  disclosures, information requirements, fees
  and marketing restrictions

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III. Investment Strategies

• Convertible Bond Arbitrage
• A typical arbitrage trade is holding a
  convertible security long and its underlying
  stock short. This is a relative value strategy
  in which returns should be made as the underlying
  stock and convertible bond move up or down in
  price.
• Dedicated Short Bias
• Commonly referred to as short sellers. Often
  use intensive fundamental analysis to uncover
  accounting problems or frauds that could cause
  security price to fall.
• Distressed
• Focuses upon the purchase of debt instruments
  that are mispriced on an absolute or relative
  basis. Distressed securities include the
  securities of companies in trouble involved in
  workouts, liquidations, reorganizations,
  bankruptcies and similar situations. Requires
  superior fundamental analysis and accurate
  evaluation of the value of the company. A
  relative value variant is capital structure
  arbitrage where a manager is long senior debt and
  short junior securities.

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Investment Strategies

• Emerging Markets
• A specialty area where there can be more
  inefficiencies found in the valuation of
  securities. Typically can invest in both
  equities and debt. Sovereign risks and liquidity
  are the key concerns in these markets.
• Equity Market Neutral
• Trade generation is typically quantitative and
  model-driven. An example is statistical
  arbitrage where managers take advantage of small
  equity pricing anomalies through the rapid
  turnover of large portfolios. Another strategy
  is pairs trading which employs the matching
  purchase and sale of similar securities.
• Fixed Income Arbitrage
• Can be divided into mortgage and fixed income
  relative value sub-strategies. Mortgage
  strategies involve the purchase of mortgage back
  securities and hedging of risks including
  interest rate risk or duration. Relative value
  strategies involve the sale and purchase of fixed
  income instruments where carry is an important
  source of profits. Fixed income strategies in
  general employ higher levels of leverage.

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Investment Strategies

• Global Macro
• Mangers seek opportunities in markets around the
  world. The strategy is not typically restricted
  to a given asset class and is therefore highly
  opportunistic in nature. Global Macro managers
  examine macroeconomic data in order to develop a
  fundamental economic outlook or to identify a
  developing trend. Positions are taken in
  interest rate, credit, foreign exchange, or index
  derivatives.
• Long/Short Equity
• Equity alternative where managers invest long and
  short in stocks. As with traditional equities,
  managers often specialize by geography, industry,
  style and capitalization.
• Managed Futures
• A systematic strategy separated into
  trend-following and mean-reverting models.
  Trend-following systems model financial time
  series over short, medium and long term looking
  for price trends that can be exploited.
  Mean-reverting strategies expect dislocations
  from the mean to revert.

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Investment Strategies

• Risk Arbitrage
• Involves the purchase and sale of securities of
  two companies involved in a merger with the
  intent of going long or short the closure of the
  transaction. May also invest in reorganizations
  and spin-offs.
• Note Descriptions were generally taken from
  CSFB materials.

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IV. Case 1. Mortgage Derivative Hedge Fund

• Business History
• 1999 4 million managed, 1 investor, 5
  employees,3-year return 35 per year net of
  fees, for regulatory purposes losing financial
  backer
• 2004 1 billion managed, over 100 investors, 15
  employees, 7 year return 30 /year net of fees,
  owned by employees, Atlantic and the first large
  investor
• 2004 Projected to have 20-30 million profit

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Mortgage Derivative Hedge Fund

• Investment Strategy
• Core I/Os (interest only mortgage strips)
• assets High yield, but very large negative
  duration
• 500 exposed to prepayment risk
• Securities evaluated on a loan by loan basis
• Leveraged up to 2 to 1
• Hedge Interest rate exposure hedged to 0
  duration with Treasuries and MPT purchased
  forward
• Prepayment risk hedged with P/Os and other, all
  risk factors hedged dynamically

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Mortgage Derivative Hedge Fund

• Management Issues
• Liquidity 15 cash, 12 repo lines double dealer
  haircut
• Pricing Mark to market always vs. mark to model,
  complete transparency of process
• Professionals Avg. 15 year experience from
  proprietary head trader positions, one-third
  Phds
• Success Storybook success so far

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V. Case 2. Macro Economics Hedge Fund

• Business History
• 1993 - 1999 Initial development of LAB Model at
  Harvard
• 1999 - 2003 LAB Account 1-2 million invested,
  with average return near 40 annually
• 2003 Started Atlantic Macro Economics Fund, 1.5
  million invested
• 2004 Returned 26 last 13 months, annual expenses
  about 700,000

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Macro Economics Hedge Fund

• LAB Model

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Macro Economics Hedge Fund

• Investment Strategy
• Equilibrium level for interest rates is
  correlated historically with actual rates
• Forecast is yield one month out for 10-yr. spot
  and the yield difference between the 10-yr. and
  1-yr.
• Based on the forecast, cash portfolio duration is
  increased or decreased each month
• If correct, short-term gains accumulate

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Macro Economics Hedge Fund

• Management Issues
• Forecast Accuracy Statistically correct 65 of
  the time
• Volatility of Returns Take only measured bets,
  use stop-loss trading
• Start-up Marketing Seeking anchor investor,
  prospective investors will watch and wait
• Commitment Must have multi-year commitment to
  have possibility of success

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Summary
Hedge Fund Industry Start-ups 1,000 annually
est. Terminations 10-25 annually
est. Reasons 50 caused by business operational
failures est. Winners A 1 billion fund earning
20 in one year has a performance fee of 40
million Failures Long Term Capital lost .5
billion in one day with a 3.6 billion bailout at
the end (1998)
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Summary

• Hedge funds are now a booming business
• Attracting the most talented managers
• Alternative for sophisticated investors seeking
  better returns
• Words of Wisdom Investing for consistently
  good returns is very difficult. Hedge fund
  business success is very very difficult.

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Appendix

• Web pages to follow.

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