Q:  What is the history of Hatteras Funds? A : Founded by David B. Perkins in 2003, Hatteras Funds provides unique alternative investment solutions for financial advisors and their clients. Currently, the firm has $2.2 billion in assets under management. Hatteras Funds is unique because it makes alternative investment strategies available to investors in a variety of product structures ranging from daily liquid mutual funds to less liquid solutions that combine both hedge funds and private equity funds in one portfolio. Q:  What is the objective of the Hatteras Alpha Hedged Strategies Fund? A : The objective of the fund is to provide investors with consistent returns with low correlation to traditional financial market indices while maintaining a high correlation to the HFRI Fund of Funds Composite Index. The Fund is designed as a core alternative investment solution for hedged strategies. Q:  Would you highlight some of the different strategies employed by the Hatteras Alpha Hedged Strategies Fund? A : There are five main strategies that make up the Hatteras Alpha Hedged Strategies Fund – Long/Short Equity, Market Neutral, Relative Value – Long/Short Debt, Event Driven, and Managed Futures. Long/Short Equity is a strategy aimed at taking advantage of rising and falling stock prices while focusing on bottom-up investing. While there is some beta or exposure to the market, it is generally less volatile than equities and has delivered better risk-adjusted return. The strategy is different in that we are going long with securities that we like, and if we think a stock is going to go down, we also have the ability to short. We are looking to profit on both sides of the portfolio. A perfect environment for that type of strategy tends to be one where equity markets are rising. Typically, long/short equity is going to have a net exposure to the market of greater than 20%. Market Neutral managers look to profit both long and short within the equity space but they are not taking net market exposure. Relying on a more defensive allocation within the portfolio, the strategy tends to deliver better returns in times of higher volatility and declining markets. We will typically limit our net exposure to no more than plus or minus 20% to the market. Relative Value – Long/Short Debt investment managers utilize a strategy that is similar to long/short equity in that they are looking at the fundamentals of both the companies and the securities. However, these managers generally focus on debt-related securities. At the same time, Event Driven managers look for catalysts to drive their returns. As they primarily focus on corporate events such as mergers, spinoffs, divestitures, bankruptcies, or distressed companies, they generally benefit from these situations by identifying a catalyst with the potential to unlock the fundamental value of a company. These managers again will go across equity and debt and they will often provide exposure to both asset classes within their portfolio. What is unique about the Event Driven approach is that this type of investing is going to be much more uncorrelated to the market than a long/short equity strategy would be. The last strategy in our spectrum is Managed Futures. When talking about futures markets, the most favorable situations are those when volatility picks up during stressed periods within the markets. Q:  What kind of managers do you prefer to invest with? A : We are looking for managers who have not only delivered attractive risk-adjusted returns but who have also invested in liquid securities. Our goal is to avoid investing too much in deep value, distressed or concentrated activist portfolios. Instead, we want to take advantage of the more liquid opportunities that are available across the hedge fund spectrum. Q:  How do you decide which investment strategies to pursue? A : We began by looking at the HFRI Fund of Funds Composite Index’s methodology for breaking down the types of hedge fund strategies. HFRI breaks its categories into Long/Short Equity, Relative Value, Managed Futures, and Event Driven. Q:  How do you select managers? A : As a first step, we set up an asset allocation framework, which helps us achieve the broader investment objective. Then we will go through and populate each of those strategies with managers that we feel would be at the top within the categories. Since we do not have a particular type of manager that we are looking for, we often find hedge fund managers with a particular area of focus or a different segment of the market that they know very well. We have found that adding such a manager to the lineup of very dissimilar managers results in a much better portfolio than the exposure to any one of those single managers alone. We tend to have a preference for managers in the earlier stages of their investment cycle because many studies have shown that emerging managers tend to outperform within the earlier years. Another reason why we tend to focus on emerging managers is that we generally follow managers with a proven process and whose team is looking for ways to grow their firm. They view us as an attractive way to go about doing that without giving up any ownership of their business. As far as we are concerned, this is an opportunity to work with a small, select group that is not overburdened by too many assets. Q:  How do you carry out your manager research process? A : We have two dedicated analysts who are responsible for the manager research. Additionally, co-portfolio manager, Robert Murphy, and I get very involved in sourcing and conducting the due diligence on managers. Some of the traditional sources that we use would be prime brokers for introductions to managers. We are constantly traveling and we attend a lot of industry conferences. For us, these are great places to network, to build relationships, and to meet a lot of managers. We typically have a pipeline of more than 20 managers that we communicate with at any point in time. Based on the needs within our portfolio or any standouts within that pool of managers, we will present a handful of managers to the Board of Trustees on a quarterly basis. Because we are a mutual fund, every one of our sub-advisors, who are hedge fund managers, needs to be approved by the independent board of directors at quarterly meetings and be registered with the SEC. What we would expect to see is a natural progression of managers coming into the portfolio as well as going out of the portfolio over time. We believe that every year we should expect to have at least some turnover in our portfolio. We have a focused portfolio with anywhere between 20 and 35 managers at any point. In sum, the process of selecting managers is again based on sourcing aspects, networks, and relationships. Q:  Would you elaborate on the due diligence of new managers? A : We meet on a weekly basis to discuss some of the managers that we are currently reviewing. Typically, analysts are going to have several calls with the manager and will also do an on-site visit with them. After requesting certain standard information to understand their exposures over time and drivers of returns, we put together all of our findings in a formal research report on each one of the managers. Once we have completed the formal research report that comes from calls, meetings, and notes, we will follow up with on-site visits to the manager. From there, we go through the manager’s research reports and process, digging in and using all the new information gained to formalize the research report. As part of the business aspect of our scrutiny, we talk to managers about their ongoing viability, growth plans pertaining to their asset base, and their team. Should we feel comfortable with the investment process and results, the team structure and stability of the business, we will do a separate compliance review. At that stage, our chief compliance officer has a whole set of separate questions for every one of these managers. The last stage of the examination process is our detailed risk review. Not only do we want to assess if the portfolio makes sense but also if it is complementary to our existing set of managers. From there, we present all the information in the formal review to the independent board of trustees. At that point, the board spends more time to ensure that we followed all the steps discussed above. Assuming the board approves a manager, we begin the process of opening up the accounts as well as drafting a mandate in the investment agreement. With the mandate we have for each manager, we define their responsibilities by setting limitations on maximum position size, sector concentration, exposures, and other metrics. As a further step, we will set up a formal investment advisory agreement, allowing them to act as sub-advisors in our portfolio. The key point to think about from the manager’s perspective is that we are going to allocate to accounts typically no more than twice a month. Again, that helps the manager control the liquidity in the form of daily flows in and out of our mutual fund. Q:  What kinds of risk do you focus on and how do you contain them? A : Risk is embedded in every different aspect of what we do and it will largely depend on the market environment. To address this critical issue more efficiently, we talk about risk measurement and risk management. The risk measurement exercise focuses on understanding our exposures and behavior. We have daily and monthly data points that we put together to understand various metrics such as volatility, correlations, and drawdowns, which help us understand how our portfolio is behaving both on a standalone basis as well as in comparison to long-only benchmarks and hedge fund benchmarks. We also monitor the transparency at a security level to understand what sort of concentration and liquidity risk we are taking and, in terms of market segments, whether it is associated with a particular sector or region. Our approach to managing risk is based on diversification by strategy and manager and our ability to calibrate our allocations to managers. We believe that the combination of transparency and the additional level of data at the manager, strategy, and fund level allows us to make better decisions with the underlying risk in our portfolio. The most compelling feature of our risk management, however, is that it is pervasive throughout our process of selecting, evaluating, monitoring, and in some cases terminating managers.