Better Answers to Tougher Questions: An Interview With a Portfolio Manager Who Looks Forward to 2012

This article appeared in the November 2011 edition (2011, n.3) of this global publication

rying to get straight answers from portfolio managers about the markets ability to provide opportunities for investors today is like trying to herd catselusive, difficult, and likely to fail. There are lots of opinions about whats happening in the global markets and political

landscape, but translating those opinions into an investment context proves challenging beyond the typical investors ability. It is refreshing then to hear from two partners at Hercules Management Group, LLC, a New York-based, long/short pairs trading fund with a 5 year track record offering a market neutral, absolute return strategy with low volatility and positive performance in all years since inception. Paul Cantor, CFA, the funds founder and portfolio manager, responds to Diane Harrison, managing director of business development, on a range of issues posed by the investor community, and offers his insights about the market and his approach to investing that the average investor can get his arms around. DH: The long/short equity space has no shortage of value-add managers in the hedge fund community. What compelled you to create another approach in a well-populated space? PC: I first consider the risk/ reward equation. The amount of reward one should expect to receive should be commensurate with the amount of risk one is taking. Most long/short managers are not market neutral, nor are they appropriately hedged. They make levered directional bets with disparate investment vehicles that dont truly hedge their market risk. Generally, they are significantly net long, often with high beta story stocks, and try to hedge or reduce the resulting market exposure through timing the market. Inevitably, this proves more difficult than expected and the true risk in their strategy becomes evident after the fact. This result was appallingly obvious in 2008. Returning to the why create another strategy question, I felt that a strategy that was truly hedged, market neutral, non-correlated to the market, and that offered good returns and low volatility could carve out a place in the asset allocation pie. DH: Investors and their advisors are always trying to assess the brains behind the strategy. Can you share with us who you are and how your career path prepared you to manage your fund?

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Better Answers to Tougher Questions: An Interview With a Portfolio Manager Who Looks Forward to 2012
PC: I started in 1982 on the sell side of the industry. I spent 7 years learning that side of the business from an institutional perspective, working at some of the largest brokerages in the world. By 1989, it had become apparent to me that I enjoyed and was quite good at researching investment ideas, both long and short. I moved to the buy side to challenge myself and to reap the economic rewards of my investment ideas. I earned the CFA designation in the first few years of my tenure on the buy side to further formalize my investment education. I was lucky enough to work with some truly brilliant people who helped me to hone my investment style and process. In 1996, while working at one of the top institutional money manager firms, I was recruited to become a partner at a well-known hedge fund to run a utility long/short pairs strategy. The strategy was appealing because the utilities industry was going through a deregulatory process which created large changes in the earnings power of the companies. By correctly identifying the mispricings in the market of these securities, we were able to generate excellent returns for our clients. Additionally, given the high correlations between the companies, the ability to correctly hedge the positions, thereby reducing the risk in the portfolio, was excellent. What became obvious to me was that at some point down the road, the deregulatory process would come to an end and the strategy returns would become more normalized. So, I worked to create a strategy with the same best of breed practices I used in the utility pairs strategy, but which could be applied across the breadth of the US equity universe. After a long development phase, I wanted to develop a track record and vet the strategy with my own money. Today, the strategy has a 5 -year track record which has proven itself successful in some of the most difficult markets in history. DH: How did you come to develop this strategy and what convinced you that it would work? PC: Essentially, I aggregated the experience and knowledge I had gained in the industry over my 25year career. I believed that, ultimately, stock prices are driven by the earning streams of the companies. If one could isolate and identify the relative value of companies within the same industry, as we did in utilities, then one should be able to create a well-diversified portfolio of pairs that would be market agnostic in terms of direction. These would be truly hedged, as each intraindustry pair would be subject to the same macro factors. Thus, you could be long and short a pair of railroad companies, or food companies etc. This a very different portfolio in its risk/reward outlook than a fund that is long a technology stock and short a food stock or some S&P futures against it. It turns out that there was a tremendous amount of academic research that had been done on these concepts. After fully researching the
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Better Answers to Tougher Questions: An Interview With a Portfolio Manager Who Looks Forward to 2012
ideas, I created a program that I was able to back test with the model. When the back test demonstrated that the strategy had merit, I had the confidence to go out and prove it in the market place. I knew that I would require at least a 3-year track record to be able to market it to the high net worth and institutional client space for which it was designed. Thus, I was fully prepared to spend 35 years in development before going to market. DH: What opportunity does our current market environment offer in executing the strategy? How can you take advantage of the new normal many managers are struggling to navigate successfully? PC: While the current market environment is a difficult one in which to raise capital, post-Madoff and the 2008 calamity, it actually is quite good for our strategy. Given the structural debt issues worldwide, we expect a low return, highly-volatile market environment to persist for many years. Additionally, we believe the risks are skewed to the downside. Since we invest in large-capitalization, listed US equities, we offer the most liquidity and transparency of any strategy available. We have a proven investment philosophy, a fully-defined, tactical trading advantage, and an established risk discipline that permeates the entire investment process. DH: The Whats In It For Me? answer often gets buried under the Look What I Can Do tendency of the investment management community to extol their individual virtuosity in money management. Can you elaborate on the particular benefits to the investor that you provide? PC: Since we have proven non-correlated returns with a fraction of the volatility of the market, we believe that this strategy merits a place in the asset allocation discussion. Why not invest in a strategy that can deliver equity-type returns while fully hedged and truly market neutral? Our strategy has a trading discipline that allows us to take advantage of shorter-term market volatility while maintaining a long- term, fundamentally-driven outlook. This strategy allows investors to maintain market exposure while reducing their overall risk profile across their asset allocation spectrum. The strategy is fully scaleable, transparent, and has been remarkably consistent through these historic years since its inception in 2006. Over a market cycle of many years, this strategy should outperform the broad market by avoiding large losses while posting steady returns. It is not a linear return profile, and doesnt mean we cant have a bad quarter, but it does work. In these uncertain times, having a portion of overall assets in this type of strategy, to preserve wealth and grow it carefully, seems to me to be a tremendous advantage. Since we have a long-term outlook, we have low portfolio turnover and thus should be relatively tax efficient. Additionally, because our strategy is straightforward to implement, we dont have untenable

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Better Answers to Tougher Questions: An Interview With a Portfolio Manager Who Looks Forward to 2012
investment gates or liquidity restrictions. All of these factors accrue positively to an investors appetite for attractive return with acceptable risk. DH: What are some of the advantages/potential risks that investors need to balance when considering a strategy allocation such as this in their portfolio? PC: Investors need to understand the risks inherent in any strategy, as well as the limitations. Since we are truly a hedged vehicle, we will generally underperform, by definition, in a straight-up market environment. We should still earn good returns, but they will not look like the highly-levered, directional returns of the long/short universe. That being said, attempting to constantly adjust your manager selection to time market environments is arduous and difficult at best. When going through the allocation process, investors need to understand what type of risk capital they are committing. Clearly, some should be allocated to the high-risk, high-return strategies in order to create a positive skew to the return equation. Similarly, some should be allocated to our space to insure some consistency of returns and preserve capital. To quote Warren Buffet Rule # 1 in investing dont lose money. Rule # 2 remember Rule #1. DH: Finally, what excites you about these markets? Why is this the right time to consider such a strategy as a component of an overall portfolio construction? PC: Going back to what I said earlier, a volatile, low-return environment is an extremely difficult one in which managers can expect to post consistent high returns. Those that do will have highly bipolar risk/return profiles. They will likely either win big or lose big, meaning their investors will do the same. Investing in a strategy designed to have steady returns which can take advantage of shortterm opportunities created by market volatility should prove to be effective over time. When coupled with an extremely strong risk discipline which dampens return volatility and market exposure, this strategy should help investors to create a stronger risk-adjusted portfolio allocation. Protracted global economic issues, low interest rates, and persistently unpredictable market conditions are likely to be with us for the indeterminate future. Learning to defensively position a portfolio against these challenges provides some way for investors to gain a measure of control within their own risk/reward objectives. One thing is for certain as we look ahead to 2012 there is no one right answer to todays difficult market issues. Perhaps the best investment offense is in creating a strong defense.

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Better Answers to Tougher Questions: An Interview With a Portfolio Manager Who Looks Forward to 2012

Paul Cantor, CFA is Co-Founder and Managing Member of Hercules Management Group, LLC. He launched Hercules Trading Fund, LLC in 2007, after developing the investment approach and actively trading its strategy since 2006. With over 25 years trading experience as both a proprietary trader and an institutional portfolio manager, he was responsible for trading and research at Hamilton Partners, Suffolk Capital Management, Prudential-Bache Securities, and Daiwa Securities America, among others, gaining a broad range of investment management experience through diverse market cycles. Paul graduated with honors from the University of Rochester where he received his B.A. in economics, and has held the CFA designation since 1993. For more information, please contact Paul at: pcantor@herculesmgmt.com

Diane Harrison is Managing Director of Business Development and a partner at Hercules Management Group, LLC. Diane has over 20 years of expertise in marketing, investor relations, and communications, including establishing and recreating hedge funds marketing identity, creating sales collateral, and all forms of client communications. She received a B.A. in English and communications magna cum laude from Fairleigh Dickinson University. A published author and speaker, her work has appeared in a variety of industry publications and information channels, including: contact Diane at: dharrison@herculesmgmt.com AllAboutAlpha, FINAlternatives, International Alternative Investment Review (IAIReview), and Opalesque. For more information, please

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