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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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