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
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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?
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What is a Hedge Fund?
Formal definition – there is none
Webster’s 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
Convertible Arb
Relative Value
5.9%
Arb
14.7%
Other
4.3%
Equity Long
Biased
4.3%
Long/Short
Equity
25.1%
Global Macro
18.7%
Fixed Income
Arb
7.6%
Equity Mkt
Neutral
2.5%
Event Driven
17.0%
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Industry Overview
Hedge Fund Asset Growth, $Billions
1000
$875
800
$600
600
$350
400
$190
200
$50
0
1990
1995
1998
2002
2004
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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
12.3
9.8
16.2
15.3
15.8
8.1
4.4
S&P 500 Index
Morningstar Average Equity
Mutual Fund
LB Aggregate Bond Index
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Industry Overview
Who invests in hedge funds?
1992
Institutions %
19
Individuals %
81
2002
52
48
Investors Include:
High Net Worth Individuals
Family Officers
Private Banks
Endowments & Foundations
Pension Plan Sponsors (ERISA)
Retail Investors
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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 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
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leverage.
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 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
2004
2004
$4 million managed, 1 investor, 5 employees,
3-year return 35% per year net of fees, for
regulatory purposes losing financial backer
$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
Projected to have $20-30 million profit
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Mortgage Derivative Hedge Fund
Investment Strategy
Core
assets
I/O’s (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/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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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
r
Inflation
(nominal short term
interest rates)
IS
PC
P
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
Failures
Long Term Capital lost $.5 billion in one day with a
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$3.6 billion bailout at the end (1998)
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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