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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

Order of Topics
I.
II.
III.
IV.

V.

VI.

What Is A Hedge Fund?


Industry Overview
Investment Strategies
Case 1. Mortgage Derivative
Hedge Fund
Case 2. Macro Economics Hedge
Fund
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?

What is a Hedge Fund?


Formal definition there is none
Websters Dictionary has hedge
between hector and hedonism
with three definitions:
1.
2.
3.

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 industry
typical characteristics
1.
L.P. or L.L.C., or other corporate structure
2.
Formed onshore or offshore or both
3.
Unregistered investment vehicle for QPs only
4.
Both asset based and performance based
5.
Managers are small special purpose firms
6.
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

Industry Overview
Hedge Fund Asset Growth, $Billions

Industry Overview
Hedge Fund Net Performance
January 1998 June 2004

CSFB/Tremont Hedge
Fund Index
MSCI World
S&P 500 Index
Morningstar Average
Equity Mutual Fund
LB Aggregate Bond Index

Net
Compound
Annual
Return

Standard
Deviation

7.8

7.6

6.2
12.3
9.8

16.2
15.3
15.8

8.1

4.4

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)
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Industry Overview
Hedge Fund Regulation
Typically
i.
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 Advantages
Removes restrictions and requirements with
respect to:
i.
Use of leverage and short-selling
ii.
Computation of NAV, the basis for
determining fees
iii. 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

Dedicated Short Bias

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.
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

Equity Market Neutral

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.
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 14
interest rate risk or duration. Relative value strategies

Investment Strategies

Global Macro

Long/Short Equity

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.
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
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looking for price trends that can be exploited. Mean-

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
assets

I/Os (interest only mortgage strips)


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
R
(real long term
interest rates)

IS and LM intersect at the


theoretical equilibrium level for
interest rates

LM

Inflation

(nominal short term


interest rates)

IS
PC

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

(inflation rate)

Investment Savings
I (R) + NX = Y - C - G
Phillips Curve
P = f (Y, P 1 )

Inflation

Y (output)

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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
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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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