The document presents an overview of hedge funds, detailing their history, mechanics, and strategies for generating returns. It discusses the advantages and risks associated with hedge funds, including the structure, fee arrangements, and the importance of due diligence for investors. The presentation highlights the evolution of hedge fund strategies from risk management to pursuing alpha generation, particularly in the context of market conditions.

1. Just what is a Hedge Fund, anyways?
To the Greater Philadelphia Senior Executive Group
Financial Executives Sub Group
June 11, 2009
PRESENTED B Y: DICK HOOEY

2. Legal Disclaimer
This presentation is intended for general
information purposes only and should not be
construed as investment advice. It does not
constitute an offer or solicitation of an offer to buy a
security or investment. The opinions expressed
herein are solely those of the author.

3. RICHARD G. HOOEY
Strategic Finance Executive with expertise in relative valuation
and decision support analyses
Nine years evaluation of Mergers, Acquisitions, New Business
Ventures, Large Capital Expenditures Capital Market
Transactions and Corporate Investment Programs
Thirteen years managing market neutral equity portfolios (up
to $100 Million in capital) in fundamental-based and
quantitative environments
Primary Coverage: Utilities, Pharmaceuticals, Healthcare,
Consumer Goods, Retail, Restaurants, Media, Transportation
Secondary Coverage: Financials, Technology, REITs, Energy,
Insurance, Paper & Forest Products, Telecommunications

4. Today‟s Objective
Some History
Some Basics
Recent Evolutionary Trends
What now, what next?

5. Idiomatic
hedge [ hej ]
2. protective method: a means of protection against something, especially a means of
guarding against financial loss
"I, I, I myself sometimes, leaving the fear of God on the left hand and hiding mine
honour in my necessity, am fain to shuffle, to hedge and to lurch ."
William Shakespeare, Merry Wives of Windsor - 1598
"You think that you have Hedged in that Debt by a greater, by your Letter in Verse.“
John Donne's Letters to Sir Henry Goodyere, circa 1620
"Now, Criticks, do your worst, that here are met; For, like a Rook, I have hedg'd in my
Bet."
George Villiers, The Rehearsal - 1672

6. The Beginning
 1949 - Alfred W. Jones
 1966 - Carol Loomis

7. The Simplest Form
 You have a strong belief that one company is
undervalued, especially relative to its peers.
 You have no opinion on the direction of the market
but are concerned that you can be right and still lose
capital if the market falls
Solution:
Buy the undervalued company and sell short an
equivalent dollar amount of its overvalued
competitor

8. A Simple Pairs Trade
 Pesky Soda Company (NYSE: PES) $40.28
 Coconut Cola Company (NYSE: NUT) $ 31.80
 To create a portfolio balanced by dollar invested:
 Buy 5,000 shares PES
 Sell Short 6,300 NUT

9. If the Market is Up 5%
0.07
 PES up 6%
6.0%
0.06
5.0%
 NUT up 2% 0.05
0.04
 You make 4% 0.03
2.0%
0.02
0.01
0
PES NUT DJIA

10. But, if the Market is down 6%
 PES down 4% 0
PES NUT DJIA
-0.01
 NUT down 7% -0.02
-0.03
 You make 3% -0.04
-4.0%
-0.05
-0.06
-6.0%
-0.07
-7.0%
-0.08

11. A Second Opinion

12. Two Contrasting Definitions
Generate positive returns in both rising and falling
equity and bond markets
Vs.
Generate results that are uncorrelated to equity and
bond markets

13. Shorting 101
He who sells what isn’t his’n
Must cover up or go to prison

14. Mechanics of a Short
Stock Loan Common Stock
Desk 1. Issuer
2. 1.
Short Seller
Shareholder
2.
Buyer

15. Mechanics of a Short – Key Steps
The Short Sale
1) Original shareholder holds stock with custodian – agrees that the
shares are available to short.
2) Short Seller “borrows” shares from custodian - obligation to deliver
shares in future – subject to call
Dividend Payments
1) Issuer payments accrue to the original shareholder
2) Short Seller pays the dividend to the Buyer
Custodian Issues
─ Shorts typically collateralized by long positions
─ Sales proceeds also held as collateral
─ Short Seller receives interest on cash position – Short Interest Rebate

16. Sentiment vs. Reality of Short Selling
Negative Sentiments towards short selling
 Contrary to most enlightened self interests
 Hope for the worst
 Spreading negative rumors
 Shady trading techniques
Actual Benefits of Short Selling
 Price Discovery
 Provision of Liquidity

17. Characteristics of Hedge Funds
 Limited Partnership Structure
 Lower level of Regulation
 “Knowledgeable” Investors
 Pricing
 Liquidity
 Leverage
 Fees

18. Alpha and Beta
Beta represents the correlation of a funds returns to
the return of the underlying market or index. (e.g. A
rising tide raises all boats)
Alpha represents the increment over the underlying
market return provided by the fund manager (e.g.
the value added)

19. Generating Alpha
Generating Beta is relatively easy – Index Funds – and
does not produce a premium fee.
Generating Alpha (beating the market) is harder
Strategies that consistently generate alpha have the
higher fee structure

20. Two and Twenty
Most common hedge fund fee structure has two
components:
 Two per cent of Capital Invested (paid quarterly)
 Twenty per cent of Alpha (profit generated)

21. High Water Mark
Loss – Carry Forward Provision
Incentive Fees only applicable to performance in
excess of High Water Mark
Usually increased annually
Links Managers‟ interest with Investors‟

22. High Water Mark Application
160%
140%
120%
100%
80%
60%
40%
19%
20% 12% 10% 8% 8%
0%
Yr1 Yr2 Yr3 Yr4 Yr5 Yr6
-20% -11%

23. Risks that can be hedged
 Market Risk
 Industry Risk
 Concentration Risk
 Currency Risk
Company Risk is hard to hedge

24. Notable Failures
 Long Term Capital Management – 1998
 Significant Leverage (25x)
 Russian Default
 Lack of Diversification
 Quant skills – Market knowledge?
 Madoff – 2008
 NOT a Hedge Fund
 "split-strike conversion strategy“
 Regulation was poor, not non-existent
 Too Good to be True – requires Due Diligence

25. Measuring Hedge Funds
 Returns
Not appropriate for risk mitigating strategies
 Sharpe Ratio
Return / Volatility – proxy for risk
 Sortino Ratio
Return / Downside deviation
 Bias Ratio
Designed to detect improper asset pricing

26. Hedge Fund Due Diligence
 Track Record
 Significant Investment by Manager
 Pricing Characteristics of Strategy
 Size of Fund
 Concentration Risk
 “Too Good to be True”
 Third Party Involvement
 Auditors
 Administrators

27. Red Flags
 Manager looks outside Original Strategy
 Cash on hand
 Response Times to Inquiries
 Terms of Investment Agreement
 Sub – Advisors
 Redemption Gates
 In-Kind Redemptions
 Manager of Previous Fund

28. Hedge Fund Defaults
1994 – 0.3995% (751 Funds)
1998 – 0.5216% (1,917 Funds)
2004 – 0.2157% (5,563 Funds)
More current data not available

29. 2008 Returns – Credit Suisse Tremont Indices
Up Down
Style Return Funds Funds Best Worst
Managed Futures 18.3% 28 3 93% -4%
Dedicated Short 14.9% 7 2 68% -49%
Global Macro -4.6% 19 18 66% -68%
Event Driven -17.7% 9 67 33% -75%
Equity Long / Short -19.8% 19 147 47% -77%
Multi-Strategy -23.6% 4 29 26% -93%
Fixed Income Arbitrage -28.8% 8 24 14% -65%
Emerging Markets -30.4% 2 67 27% -78%
Convertible Arbitrage -31.6% 1 21 12% -61%
Equity Market Neutral -40.3% 9 12 36% -100%

30. Conclusions
 Hedge Funds were originally intended to manage
risk, especially of down markets
 Fee structures evolved to compensate managers for
the more difficult task of generating alpha
 Bull markets in late „90‟s led to more managers,
often charging “alpha” fees for “beta” strategies
 Like in 1973-74, 2008 has exposed many of these
strategies
 Now more than ever, due diligence is key in choosing
Hedge Fund managers