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Hedge Funds

The Indebted SocietyEconomics 1813

Harvard University

Michael DubilierDubilier & Company

Ronald W. SellersAtlantic Asset

Management, LLC

Stamford, Connecticut203-351-2800

www.atlanticasset.com (research tab)

November 22, 2004

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Order of Topics

I. What Is A Hedge Fund?II. Industry OverviewIII. Investment StrategiesIV. Case 1. Mortgage Derivative

Hedge FundV. Case 2. Macro Economics Hedge

FundVI. Appendix – Web Pages

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I. What is a Hedge Fund?

Class questions:1. How many have heard of hedge

funds?2. How many think they know what

they are?

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What is a Hedge Fund?

Formal definition – there is noneWebster’s Dictionary has “hedge”

between “hector” and “hedonism” with three definitions:1. boundary2. means of protection3. 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 industry–typical characteristics

1. L.P. or L.L.C., or other corporate structure2. Formed onshore or offshore or both3. Unregistered investment vehicle for “QPs” only4. Both asset based and performance based5. Managers are small special purpose firms6. Operate a single investment strategy for

absolute total return 7. Hedging is used to reduce certain investment

risks 8. Leverage is used to enhance returns

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II. Industry Overview

$875 billion assets in about 6,000 Hedge Funds

Fixed Income Arb

7.6%

Event Driven17.0%

Equity Mkt Neutral2.5%

Long/Short Equity25.1%

Equity Long Biased4.3%

Relative Value Arb

14.7%

Global Macro18.7%

Other4.3%

Convertible Arb5.9%

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Industry Overview

Hedge Fund Asset Growth, $Billions

$50

$190

$350

$600

$875

0

200

400

600

800

1000

1990 1995 1998 2002 2004

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Industry Overview

Hedge Fund Net PerformanceJanuary 1998 – June 2004

Net Compound

Annual Return

StandardDeviation

CSFB/Tremont Hedge Fund Index

7.8 7.6

MSCI World 6.2 16.2S&P 500 Index 12.3 15.3Morningstar 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 52Individuals % 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

Typicallyi. They are exempt from registration under

the Investment Company act of 1940, and therefore not public mutual funds

ii. They are exempt from registration under the Securities Act of 1933, and therefore cannot make public offerings

iii. 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:i. Have less than 100 investors or sell

interests only to “qualified purchasers” (with $5 million of investments)

ii. Do not offer securities publicly – no public solicitation

iii. Have 14 clients or fewer – hedge fund is “one”

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Industry Overview

Investment AdvantagesRemoves restrictions and requirements with

respect to:i. Use of leverage and short-sellingii. Computation of NAV, the basis for

determining feesiii. Extensive reporting and disclaimer

obligations, including printed prospectus approved by the SEC

iv. 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/O’s (interest only mortgage strips)

assets High yield, but very large negative duration

500% exposed to prepayment riskSecurities evaluated on a loan by loan basisLeveraged up to 2 to 1

Hedge Interest rate exposure hedged to ‘0’ duration with Treasuries and MPT purchased forwardPrepayment risk hedged with P/O’s 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 Phd’s

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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Liquidity of Money M/P = L (r, Y)

R (real long term interest rates)

LM

r (nominal short term

interest rates)

Y (output)

IS

PC

Infla tion

Inflation

IS and LM intersect at the theoretical equilibrium level for

interest rates

P (inflation rate)

Investment Savings I (R) + NX = Y - C - G

Phillips Curve P = f (Y, P –1 )

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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