Hatteras Alpha Hedged Strategies Fund (ALPHX | ALPIX) Quarterly Review | 2Q2012

Net Fund Operating Expenses are contractually capped at 3.99% for ALPHX and 2.99% for ALPIX through April 30, 2013, excluding dividends on short positions and interest on borrowing as well as other extraordinary items disclosed in the prospectus. Total Annual Fund Operating Expenses are 4.82% for ALPHX and 3.82% for ALPIX. Class I Shares of Alpha Hedged Strategies Fund were not in existence prior to September 30, 2011 and have a minimum investment of $1 million. Performance for any periods prior to the inception date of Class I, are based on the historical performance of the No Load Shares adjusted to assume the expenses associated with Class I Shares. Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Funds may be lower or higher than the performance quoted. To obtain performance information current to the most recent month-end, please call 866.388.6292 or visit www.hatterasfunds.com. 1. Average annual total return 2. Fund inception date: ALPHX 09/23/2002; ALPIX 09/30/2011, Since Inception performance for Class I is since 09/23/2002.

Three Years Forward

We would like to begin our quarterly letter reviewing the progress of the Hatteras Alternative Mutual Fund business since July 2009, when we signed a definitive agreement to acquire the investment manager of the (Hatteras) Alpha Hedged Strategies Fund (the “Fund”). We took a unique and industry-leading structure, added resources to the investment team by appointing Bob Murphy and Mike Hennen as portfolio managers, and implemented robust asset allocation and risk management processes to help financial advisers and their clients access high quality hedge fund managers in a daily valued, daily liquid, fully transparent format. We believe the results since July 2009 are a product of the unique structure created in 2002 when the Fund was launched, and the enhancements we made upon our acquisition nearly three years ago. Before discussing the second quarter performance, let’s quickly review the Fund, Hatteras Funds’ involvement, and the results since July 2009.

First, the Fund’s unique structure and asset size give investors access to a diversified portfolio of high quality hedge fund managers that run separate accounts held by well-respected custodians. This structure gives our portfolio management and fund accounting teams 100% position leveltransparency on a daily basis. Under this structure, we have better insight into the Fund’s gross and net exposures from both an equity, as well as credit perspective, which if used properly can result in preeminent risk management and asset allocation decisions.

Second, in anticipation of our acquisition, we added two experienced hedge fund of fund professionals, Mike Hennen, CFA, and Bob Murphy, CFA, FRM, CAIA, to lead the investment management process.

We also institutionalized the investment process by:

1. Establishing a definable investment mandate: target HFRI Fund of Funds Composite Index  

(“HFRI FoF”) returns with a high degree of correlation.

2. Consolidate underlying strategies into five major hedge fund strategies – Long/Short Equity, Market Neutral, Relative Value – Long/Short Debt, Event Driven, and Managed Futures.

3. Improve asset allocation and risk management process.

Implementing these three steps required a tremendous amount of work, and is still evolving, as we strive to improve every day. The above table summarizes the results since Hatteras Funds took over the management of the Fund versus its benchmark, which we believe reflects the leading position we have in this niche.

Quarterly Commentary - Capital Markets Review

For the third year in a row, global economic conditions have deteriorated in the second quarter, resulting in weak equity returns and increased volatility. This year the problems have become more acute as solutions to the European debt crisis and the US fiscal/political deterioration have come up empty handed. Add to these concerns the significant slowing of economies in Brazil, India and China and it is easy to understand the increased malaise among investors. It is the latter of these issues which makes this environment somewhat different than 2010 and even 2011 when these major emerging economies were still growing close to the 10 year long-term average.

Examples of short-term risks abound within the Euro Zone as unemployment stands at 11.2% and is much higher in the periphery economies. The Purchasing Manager’s Index now stands at 46.4, well below the 50 level which separates expansion from contraction. In the US, the Institute for Supply Management Manufacturing Index dropped below 50 for the first time in three years as export orders to Europe and Asia have slowed. While economies like India and China continue to grow at rates well above the developed world, issues like inept government policies and an overleveraged real estate sector have spooked businesses and investors. All of this means more uncertainty for investors and further challenges to earn reasonable rates of returns on capital investment.

During the second quarter, equity markets recorded reasonable losses, especially outside the US, although it could have been worse save the last day rebound of 2-4% among major indices. Domestic equity indices lost between -2.0 to -4.0% depending on the index with the S&P 500 TR Index (the “S&P 500”) down -2.8%. For the most part defensive sectors led the way with positive returns from Consumer Staples, Health Care, Telecom, and Utilities – more than offset by bigger sectors like Energy, Financials and Consumer Discretionary.

Our concern remains the impact not only on the psychology of the global business world, but also the direct impact of a global slowdown on earnings, which have helped propel the equity markets from a March 2009 low even amidst a weak economic recovery. With short-term productivity maxed out, companies will not be able to rely on cost-cutting nor productivity gains to drive earnings like 2009-2011 and therefore corporate earnings will disappoint as business opportunities shrink. Already, many more companies have pre-announced expected shortfalls in earnings versus estimates, which together with the many uncertainties associated with Europe and the US could make for a difficult third quarter to say the least.

In this environment, the ‘safe” play has been to invest in US Treasuries, German Bunds, UK Gilts as well as the US dollar, Danish Krone and Swiss Franc. All these type of securities and their brethren had a strong second quarter. The long end of the US Treasury market produced a spectacular 10.6% return (as defined by the Barclays Long term US Treasury Index) with the general fixed income proxy (the Barclays Capital US Aggregate Bond Index) producing a 2.1% return. While the emerging equity indices were hit hard, the debt side of the equation performed well with a 2.8% returns measured by the JP Morgan Emerging Markets Bond Index Plus.

Hedge Fund Industry Review

Returns for hedge fund indices were disappointing during the second quarter, especially among many of the long/short equity managers. The sharp equity market reversals during April, May and especially June hurt most of the managers, and the final week’s rapid increase only added to the underperformance as managers tended to be fairly hedged, based on our analysis and conversations.

Review of Hatteras Alpha Hedged Strategies Fund’s Performance

Notwithstanding its relatively strong performance since July 2009, the Hatteras Alpha Hedged Strategies Fund (“ALPHX”) underperformed its benchmark in the second quarter, posting a loss of -2.6% versus -2.2% for the HFRI FoF, a loss of -2.8% for the S&P 500. Clearly the uncertainty prevailing during the quarter resulted in volatile markets. Our managed futures sub-advisors held up very well through the volatility, producing positive returns, although this defensive strategy is a smaller weighting of the Fund and therefore the positive impact was somewhat limited. The Fund’s 34% allocation to the Long/Short Equity Strategy detracted from Fund performance as the managers dealt with violent market swings.

As we will discuss later in this piece, our managers were cautious overall in the second quarter and remain so going into the third quarter. Their expertise in managing risk and our allocation strategy has proven to add value since July 2009 and we believe will give us a great opportunity to generate attractive risk adjusted returns going forward.

Long/Short Equity*

Allocation: 34%

Strategic Range: 25%-45%

The Long/Short Equity strategy detracted from both the absolute and relative performance of the Fund as it lost -4.0% versus a loss of -2.8% for the S&P 500 Index and -2.7% for the HFRX Equity Hedge Index. This strategy was hurt by net long exposure to Information Technology and option related exposure to Financials, two of the worst performing sectors for the quarter. Even though our net exposure dropped from 36% at the end of March to 23% at the end of June, our shorts as a whole did not perform as well as expected.

Market Neutral*

Allocation: 17%

Strategic Range: 5%-25%

While this strategy outperformed its benchmark and the S&P 500, it was a little disappointing from an absolute standpoint as it lost -1.7% versus a -3.4% loss for the HFRX Equity Market Neutral Index and a -2.8% loss for the S&P 500. On a relative basis, the strategy was helped by exposure and good performance from some energy and industrial names. Exposure to some technology names and a momentum driven strategy detracted from performance.

Relative Value- Long/Short Debt*

Allocation: 22%

Strategic Range: 10%-30%

This strategy was down slightly at -0.7% versus a loss of -1.4% for the HFRX Relative Value Arbitrage Index and a positive return in the Barclays Capital US Aggregate Bond Index at 2.1%. Gains in yield oriented strategies and asset-backed securities were offset by small losses in some emerging markets names, and detractions from some hedging positions. June was a pretty quiet month in the credit markets as we believe that prices reflect the European and US debt problems, unlike the equity markets. Our underlying sub-advisors feel confident on the opportunity set going forward.

Event Driven*

Allocation: 17%

Strategic Range: 10%-30%

The Event Driven strategy lost -3.2% compared to a loss of -2.7% for the HRFX Event Driven Index. This underperformance can be traced to one sub-advisor whose long-term performance is great, but got hit hard with some idiosyncratic exposures in energy and some of its hedges. Deal activity is not as robust as one would expect given the low growth, high cash level environment – clearly impacted by political and economic uncertainty that may be with us until Q4 at the very least.

Managed Futures*

Allocation: 10%

Strategic Range: 0%-20%

As the best strategy for uncorrelated returns, managed futures produced a 1.7% return versus a small loss of -0.8% for the HFRX Systematic Diversified Index. This strategy performed great in April and May when the equity markets were struggling – it recorded a loss in June mainly due to the last day of the quarter when global equity markets rebounded 2-4% in one day.

Fund Outlook

As we consolidate the information gleaned from discussions with underlying sub-advisors with our broad based indicators, we have become more concerned that near term conditions continue to point to weakness and uncertainty. Growth in the U.S. has recently shown signs of slowing and while U.S. corporations have continued to improve their balance sheets over the past few years, large cash balances have more frequently been used to pay dividends to investors as opposed to acquiring companies for growth. Risks are still prevalent and meaningful in regards to the European debt crisis, specifically Spain, and may continue to mute economic activity for this part of the world. In addition, evidence suggests that the major developing economies of China, India and Brazil are slowing. Combined with the underwhelming global growth picture, the upcoming U.S. elections and ensuing ramifications on tax policy and regulation will likely result in general risk aversion.

We believe the opportunity set in fixed income, specifically the areas outside of high-grade U.S. Corporates and U.S. Governments, remains positive. Balance sheets are in solid shape, cash flows are reasonable, defaults should remain low for the foreseeable future, and spreads remain elevated, but are close to historical averages. Therefore, from a risk-adjusted basis, this remains a relatively attractive area for us.

The resulting asset allocation changes to the Fund will mirror our above thoughts as we shift the portfolio to a slightly more defensive posture. We look to position the portfolio for an overweight to relative value-long/short debt and managed futures strategies, an underweight to long/short equity and event driven strategies, and will maintain a neutral weighting to market neutral.

As always, we value the confidence and trust you place in Hatteras Funds and the Hatteras Alternative Mutual Funds team in particular. We take our job as fiduciaries seriously and strive to exceed client service expectations. Please contact us with any comments, feedback and questions.


* The asset class and strategy return figures presented for the Hatteras Alpha Hedged Strategies Fund indicate how each strategy performed on a stand-alone basis and are not guaranteed as to accuracy. The strategies are part of an Underlying Fund Trust (“UFT”) structure. Individual investors may not invest directly in the UFT. The return figures are net of all underlying manager fees and expenses and UFT level fees. However, the strategy return figures do not reflect Hatteras Alpha Hedged Strategies Fund expenses, including fund administration fees, custody fees, fund accounting fees, etc., which would reduce the figures shown. Consequently, the information above was included for educational purposes only and should not be used to evaluate any Hatteras Alpha Hedged Strategies Fund performance. Past performance does not guarantee future results.


The opinions expressed in this report are subject to change without notice. This material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. The opinions discussed in the letter are solely those of the Investment Manager and may contain certain forward-looking statements about the factors that may affect the performance of the Hatteras Funds in the future. These statements are based on the Investment Manager’s predictions and expectations concerning certain future events and their expected impact on the Hatteras Funds, such as performance of the economy as a whole and of specific industry sectors, changes in the levels of interest rates, the impact of developing world events, and other factors that may influence the future performance of the funds. Management believes these forward-looking statements to be reasonable, although they are inherently uncertain and difficult to predict. Actual events may cause adjustments in portfolio management strategies from those currently expected to be employed. It is intended solely for the use of the person to whom it is given and may not be reproduced or distributed to any other person. This should be read in conjunction with or preceded by a current prospectus. The information and statistics in this report are from sources believed to be reliable, but are not warranted by Hatteras to be accurate or complete.


The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The summary prospectus and prospectus contain this and other important information about the investment company, and may be obtained by calling 1.877.569.2382 or visiting www.hatterasmutualfunds.com. Read it carefully before investing.

Key Risk Factors:

Certain hedging techniques and leverage employed in the management of the Fund may accelerate the velocity of possible losses. Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the Fund. Derivatives involve investment exposure that may exceed the original cost and a small investment in derivatives could have a large potential impact on the performance of the Fund. Options held in the Fund may be illiquid and the fund manager may have difficulty closing out a position. Fixed Income instruments are exposed to credit and interest rate risks. Investing in lower-rated (“high-yield”) debt securities involves special risks in addition to the risks associated with investments in higher-rated debt securities, including a high degree of credit risk and liquidity risk. The Fund may also invest in:

• smaller capitalized companies - subject to more abrupt or erratic market movements than larger, more established companies;

• foreign securities, which involve currency risk, different accounting standards and are subject to political instability;

• securities limited to resale to qualified institutional investors, which can affect their degree of liquidity;

• shares of other investment companies that invest in securities and styles similar to the Fund, resulting in a generally higher investment cost than from investing directly in the underlying shares of these funds.

The Fund intends to utilize these individual securities and hedging techniques in matched combinations that are designed to neutralize or offset the individual risks of employing these techniques separately. Some of these matched strategies include merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. There is no assurance that these strategies will protect against losses. The Fund is non-diversified and therefore may invest in the securities of fewer issuers than diversified funds at any one time; as a result, the gains and losses of a single security may have a greater impact on the Fund’s share price.

Because the Fund is a fund-of-funds, your cost of investing in the Fund will generally be higher than the cost of investing directly in the shares of the mutual funds in which it invests. By investing in the Fund, you will indirectly bear your share of any fees and expenses charged by the underlying funds, in addition to indirectly bearing the principal risks of the funds. Please refer to the summary prospectus or prospectus for more information about the Fund, including risks, fees and expenses.

Mutual fund investing involves risk; loss of principal is possible. Please consult an investment professional for advice regarding your particular circumstances. An investment in the Fund may not be suitable for all investors.

The Fund is distributed by Hatteras Capital Distributors, LLC, an affiliate of Hatteras Alternative Mutual Funds by virtue of common control or ownership.

HAMF 07-2012-38

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