May 3 (Bloomberg) -- UBS AG, the world's biggest asset manager, is winding down John Costas's hedge-fund unit after 11 months of trading and returning client money because of losses attributed to the U.S. mortgage market.

UBS will close Dillon Read Capital Management LLC amid losses of 150 million Swiss francs ($124 million). Costas, 50, who previously ran the bank's securities unit for almost four years, gained control of the hedge fund in June 2005 as an incentive to stay. Trading started a year later. Costas will stay as an adviser to the executive board, UBS said today in a statement.

``It's been an embarrassment,'' Christopher Wheeler, an analyst at Bear Stearns Cos. in London, said of Dillon Read. ``They never raised enough money for it to do more than break even.''

UBS has been hurt by hedge funds before, losing about $700 million in 1998 when Long-Term Capital Management LP collapsed. Dillon Read was slow to start the fund and raise capital, and its challenges culminated with a shakeout in the subprime lending market, Costas said today in an interview. More than 50 lenders to the riskiest mortgage borrowers have gone bankrupt or sought buyers since early 2006, according to Bloomberg data.

Dillon Read's investments will be folded into UBS, Huw Jenkins, who replaced Costas as head of Zurich-based UBS's investment bank, told Dillon Read employees Wednesday night in a meeting at a hotel in New York, according to an archived recording.

New Structure

The division's returns have been ``exceptionally good'' for outside clients and ``rather impaired'' for the bank, Jenkins said. He added that with the new structure UBS will ``better manage our own capital and also manage the capital of third parties,'' he told employees.

``We've been very concerned about you and your careers, and we feel there's been too much ambiguity and too great of uncertainty'' over the past several weeks,'' he told employees.

The hedge-fund unit ``did not meet our expectations,'' Chief Executive Officer Peter Wuffli said today in the statement. UBS's first-quarter net income fell 7 percent to 3.28 billion francs. Dillon Read contributed to a 7 percent drop in fixed-income revenue.

Closing the hedge fund will cost $300 million and save $200 million a year, the bank said.

UBS shares fell 2.05 francs, or 2.6 percent, to 76.5 francs in Zurich.

While closing the hedge fund was ``a difficult decision, it was clearly the right decision,'' UBS Chief Financial Officer Clive Standish told reporters on a conference call.

Delays

Accounting problems and other ``operational issues'' delayed Dillon Read's start of trading by six months last year, Costas said today in the interview. Problems included technology and regulatory issues, he said, declining to provide details.

The unit managed about $3.5 billion of UBS's own money and another $1.2 billion raised from outside clients last year. The outside money returned 11 percent from November through March, according to Costas and Standish. UBS didn't provide returns for its own money beyond the $124 million first-quarter loss it attributed to the Dillon Read business.

``The area that gave us some trouble was the subprime space,'' Costas said. He said problems in the fund stemmed from positions established in 2001 and 2002 that caused ``idiosyncratic risk'' for Dillon Read.

UBS, in starting Dillon Read, had wanted to offer clients the chance to invest with its traders, Standish said. The company found out that doing so meant higher-than-expected regulatory costs, he said.

Regulation Issues

``The setting up took too long because there was quite a lot of regulations and accounting issues,'' Standish said. `` We found the operating complexity was a lot more difficult than we anticipated. Rather than sitting on our hands to see if it gets better or worse, we took the decision that it's not workable.''

Hedge funds are largely unregulated pools of capital whose managers can buy or sell any assets, participating substantially in the profits of the money invested.

``If they're closing now it's not only because the last three or six months have been difficult, they must have been unhappy for a while,'' said Jean-Paul Jeckelmann, chief investment officer at Bonhote & Cie SA, a private bank in Neuchatel, Switzerland.

Analyst Reaction

``Investors are likely to be unnerved by the announcement that John Costas, who runs DRCM, will help with the reintegration of the unit back into mainstream UBS,'' Peter Thorne, an analyst at Helvea SA in London, said today in a note to clients. ``It was under Costas's leadership that UBS lost so much ground in fixed income revenue growth and, of course, he is responsible for the DRCM disaster.''

Dillon Read has 250 employees in New York, London, Tokyo and Singapore. Some of them will return to the investment bank as Dillon Read's principal finance, credit arbitrage and commercial real estate businesses are reorganized. Others won't be offered jobs, UBS spokesman Dominik von Arx said.

Jenkins told Dillon Read employees that the fixed-income business is the most promising growth area right now for UBS's investment bank, ``especially in emerging markets, structured products and credit, and leveraged finance.''

UBS will integrate Dillon Read as if it's making ``an acquisition of a very valuable outside company,'' Jenkins said.

Dillon Read President Michael Hutchins and Ken Karl, who helped oversee investments, have left Dillon Read, Costas said.

Hutchins and about 120 members of UBS's fixed-income division joined Dillon Read in 2005. Fixed-income investing dominates Dillon Read's business.

Costas

Costas was named head of the hedge fund unit in June 2005 to make fixed-income and commercial real-estate investments with UBS's own money. Jenkins, then equities chief, replaced Costas as head of the investment bank.

The unit's name came from Dillon, Read & Co., a U.S. investment bank that was founded in 1832 and bought by Swiss Bank Corp. in 1997. Swiss Bank merged with Union Bank of Switzerland a year later to create UBS. The Dillon Read name was dropped in 2000.

Costas joined UBS from Credit Suisse Group in 1996 and was named chief executive officer of the company's investment banking unit in December 2001.

Before becoming CEO, he worked as head of the company's U.S. fixed-income division and then became global head of the business. In 1999, he became chief operating officer of the investment bank, then called UBS Warburg. In 2000, he worked to integrate Paine Webber into Switzerland's biggest bank, following the $11.5 billion purchase of the No. 4 U.S. broker.

To contact the reporters on this story: Sebastian Boyd in London at sboyd9@bloomberg.net; Jenny Strasburg in New York at jstrasburg@bloomberg.net.

Last Updated: May 3, 2007 16:19 EDT