Advisors and clients who want a better understanding of how some hedge fund managers do their jobs should be interested in the following scenario. It is based upon a Feb. 9 announcement that Spectrum Pharmaceuticals Inc. agreed to license RenaZorb, a drug for phosphate control in kidney dialysis patients, from Altair Nanotechnologies Inc.

Altair has developed a technology platform for manufacturing a variety of nanomaterials and nano-based products. It can manufacture commercial quantities of a wide variety of such materials with narrow particle distribution sized from five nanometres to 1,000 nanometres.

Few investors have ever heard of the company, but, in light of recent reports about nano-technology, the stock has become a high flyer. On March 17, shares of Altair more than doubled, to close at US$4.77 a share from US$2.08 . Nice profit for one day.

In the real world, of course, a regular manager must maintain a diversified portfolio. He cannot simply put a major part of his assets into a micro-cap company such as Altai. It had market cap of about US$219 million. A portfolio manager who followed the technology sector may have held a small position.

Let’s assume the manager was forward-thinking and purchased Altair some time in the past year, say on Nov. 30, 2004, when the stock traded at US$2.80 a share.
The most exposure a traditional portfolio manager might have to Altair would be 2% of the portfolio. He would be required to hold positions in many other companies in many other industries. So, while Altair may have advanced 71% from the point at which it was purchased, it would have had only a 1.42% impact on the overall portfolio (71% x 2% of the portfolio = 1.42%).

Now, let’s look at the same investment from the eyes of a typical hedge fund manager, specifically a long/short hedge fund manager. Inside a long/short hedge fund, managers typically take sizable bets on a single position, perhaps 5% to 10% of the portfolio. Let’s assume that our hedge fund manager puts 10% of the portfolio into Altair at the same time as our traditional portfolio manager.

Since he runs a long/short hedge fund, the
manager will sell short another stock in the same sector. Or maybe he would sell short the sector, or even the market. The point is there has to be a short side to accompany the long side.

In this case, let’s say our hedge fund manager sells short biotechnology firm Amgen Inc. on the same day he purchases Altair at US$2.80. On Nov. 30, 2004, Amgen was trading at US$60 a share. If the hedge fund manager wants to be fully hedged, he will have to buy many more shares of Altair (US$2.80) for every share of Amgen (US$60) he sells short.

The hedge ratio for the trade is about 21 ($60 divided by $2.80 = hedge ratio of 21.43). He would buy about 21 shares of Altair for every one share of Amgen he sold short. After the latest rally in Altair, our hedge fund manager decides to close out the position, selling Altair at $4.77 a share, and buying back the Amgen at US$63 a share.

On the Altair trade, the fund makes $1.97 a share, multiplied by 21 shares, for a profit of $41.37. For every 21 shares the fund is long Altair, he will lose US$3 on each share of Amgen that the fund is short. The fund nets US$38.37 per long short hedge, or $1.82 net profit per Altair share. In percentage terms, the fund makes 65% on the trade (US$1.82 per Altair share divided by the cost of $2.80 = 65%). Because the fund has a 10% position in the hedge, it adds 6.5% to the bottom line of the fund.

In the hedge fund industry, the manager earns a share of the total profit, the so-called incentive bonus. Hence, rather than having to explain why the risk was taken, the hedge fund manager actually has an incentive to take risk.

It is a critical distinction. While the rewards and expectations are different, there is little to distinguish the equity fund manager from the hedge fund manager. Both added value by picking Altair. Both, then, were excellent stock pickers, but only one was rewarded for taking the risk.