Strategy Categories for Hedge Funds
In order to compare performance, risk, and other characteristics, it is helpful to categorise hedge funds by their investment strategies). Strategies may be designed to be market-neutral (very low correlation to the overall market) or directional (a “bet” anticipating a specific market movement). Selection decisions may be purely systematic (based upon computer models) or discretionary (ultimately based on a person). A hedge fund may pursue several strategies at the same time, internally allocating its assets proportionately across different strategies.
As Schneeweis (1998) notes, some hedge fund strategies (for example, fixed income arbitrage) were previously the proprietary domain of investment banks and their trading desks. One driver for the growth of hedge funds is the application of investment bank trading desk strategies to private investment vehicles.
Long-Short
Long-short hedge funds focus on security selection to achieve absolute returns, while decreasing market risk exposure by offsetting short and long positions. Compared to a long-only portfolio, short selling reduces correlation with the market, provides additional leverage, and allows the manager to take advantage of overvalued as well as undervalued securities. Derivatives may also be used for either hedging or leverage. Security selection decisions may incorporate industry long-short (such as buy technology and short natural resources) or regional long-short (such as buy Latin America and short Eastern Europe).
The classic long-short position is to choose two closely related securities, short the perceived overvalued one and long the undervalued one. For example, go long General Motors and short Ford Motors. This classic example has the greatest risk reduction since the two stocks are likely to have very similar market risk exposures. The pair-trade removes most of the market risk. Idiosyncratic risk remains, but it can be reduced with a portfolio of similar trades.
Long-short portfolios are rarely completely market-neutral. They typically exhibit either a long bias or short bias, and so have a corresponding market exposure (positive or negative). They are also likely to be exposed to other market-wide sources of risk, such as style or industry risk factors.
4.3 Relative Value
Relative value funds use market-neutral strategies that take advantage of perceived mispricing between related financial instruments. Fixed-income arbitrage may exploit short-term anomalies in bond attributes, such as the yield curve or the spread between Treasury and corporate bonds. Convertible arbitrage profits from situations where convertible bonds are undervalued compared to the theoretical value of the underlying equity and pure bond. In these cases, the hedge fund manager takes long positions on the convertible bond and shorts the underlying stock. Statistical arbitrage involves exploiting price differences between stocks, bonds, and derivatives (options or futures) while diversifying away all or most market-wide risks.
Situations for relative-value arbitrage often occur with illiquid assets, so there may be added liquidity risk. Gains on individual trades made be small, so leverage is often used with relative-value strategies to increase total returns.
Event Driven
Event-driven strategies exploit perceived mispricing of securities by
anticipating events such as corporate mergers or bankruptcies, and their effects.
Merger (or risk) arbitrage is the investment in both companies (the acquirer and takeover candidate) after a merger has been announced. Until the merger is completed, there is usually a difference between the takeover bid price and the current price of the takeover candidate, which reflects uncertainty about whether the merger will actually happen. For instance, a fund manager may buy the takeover candidate, short stock of the acquirer, and expect the prices of the two companies to converge. In this case, there may be substantial risk that the merger will fail to occur.
Bankruptcy and financial distress are also hedge fund trading opportunities, because managers in traditional pooled vehicles (such as mutual funds and pension funds) may be forced to avoid distressed securities, which drive their values below their true worth. Certain hedge fund managers may also invest in Regulation D securities, which are privately placed by small companies seeking capital, and not accessible to traditionally managed funds. Investing in distressed securities typically increases liquidity risks.
4.5 Tactical Trading
The tactical trading classification includes a large variety of directional strategies, including the subcategories of global macro and commodity trading advisers (CTAs). Global macro funds make investments based upon appraisals of international conditions, such as interest rates, currency exchange rates, inflation, unemployment, industrial production, foreign trade, and political stability. The global macro subcategory tends to contain
the largest hedge funds – earlier hedge funds, such as Robertson’s Tiger Fund and Soros’ Quantum Fund, and current funds, such as Brevan Howard and Moore. Global Macro funds receive the most scrutiny when hedge funds are accused of undermining global stability.
Global macro traders may use leverage, short sales, or derivatives to maximise returns. Some funds specialise in illiquid assets in emerging markets, which sometimes have financial markets that do not allow short sales or do not offer derivatives on their securities.
Commodities trading advisers (CTAs) specialise in speculative trading in futures markets. Trades may involve futures on precious metals, currencies, financial instruments, or more typical commodities in futures exchanges throughout the world. CTAs often use computer models to profit from differences in contract selection, weighting, and expiration. Fung and Hsieh (2001) explain “trend-following,” the strategy of a majority of CTAs, and how the strategy can show positive returns, especially in extreme markets. In the US, the Commodity Futures Trading Commission (CFTC), not the SEC, regulates the actions of CTAs.
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