LO 71.6: Compare and contrast the different hedge fund strategies, describe their return characteristics, and describe the inherent risks of each strategy.
Managed Futures and Global Macro
Managed futures funds focus on investments in bond, equity, commodity futures, and currency markets around the world. Systematic trading programs are used which rely on historical pricing data and market trends. A high degree of leverage is employed because futures contracts are used. With managed futures, there is no net long or net short bias.
Many managed futures funds are market timing funds, which switch between stocks and Treasuries. When both short and long positions are considered, the payoff function of this strategy is similar to a lookback straddle, which is a combination of a lookback call option and a lookback put option. The lookback call option gives the owner the right to purchase the underlying instrument at the lower price during the call options life, while the lookback put option gives the owner the right to sell the underlying instrument at the highest price during the put options life.
Global macro fund managers make large bets on directional movements in interest rates, exchange rates, commodities, and stock indices. They are dynamic asset allocators, betting on various risk factors over time.
Both managed futures and global macro funds have trendfollowing behavior (i.e., directional styles). Global macro funds do better during extreme moves in the currency markets. Both of these strategies are essentially asset allocation strategies, since the managers take opportunistic bets in different markets. They also both have a low return correlation to equities.
Merger/Risk Arbitrage and Distressed Securities
Merger (or risk) arbitrage strategies try to capture spreads in merger/acquisition transactions involving public companies, following public announcement of a transaction. The primary risk is deal risk, or the risk that the deal will fail to close.
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Examining merger arbitrage returns, the largest negative monthly returns in this strategy are after the S&P 500 index has had a large negative return. This equates to being long deal risk. The logic is that when the market has a large decline, mergers have a greater tendency to be called off.
Distressed hedge funds is another event-driven hedge fund style. This strategy invests across the capital structure of firms that are under financial or operational distress, or are in the middle of bankruptcy. The strategy tends to have a long bias. With this strategy, hedge fund managers try to profit from an issuers ability to improve its operation, or come out of a bankruptcy successfully.
A key feature of the strategy is long exposure to credit risk of corporations with low credit ratings. A good proxy for these types of returns is publicly traded high-yield bonds since the correlation between the DJCS Distress index and high-yield bonds is 0.55.
In sum, both of these event-driven strategies exhibit nonlinear return characteristics, since tail risk appears under extreme market conditions. With merger arbitrage, the tail risk is a large drop in equity investments. With distressed hedge funds, the tail risk is a big move in short-term rates. Unlike trend following strategies, event-driven funds are hurt by extreme market movements.
Fixed Income Arbitrage
Fixed income arbitrage funds attempt to obtain profits by exploiting inefficiencies and price anomalies between related fixed income securities. The fund managers try to limit volatility by hedging exposure to interest rate risk. An example of this strategy is leveraging long/short positions in fixed income securities that are relatedmathematically or economically.
The sectors traded under fixed income arbitrage include: Credit yield curve relative value trading of swaps, government securities, and futures. Volatility trading using options. Mortgage-backed securities arbitrage. A swap spread trade is a bet that the fixed side of the spread will stay higher than the floating side of the spread, and stay in a reasonable range according to historical trends. With yield-curve spread trades, the hope is that bond prices will deviate from the overall yield curve only in the short term, and will revert to normal spreads over time. Mortgage spread trades are bets on prepayment rates, while fixed income volatility trades are bets that the implied volatility of interest rate caps have a tendency to be higher than the realized volatility of, for example, a Eurodollar futures contract. Capital structure or credit arbitrage trades try to capitalize on mispricing among different types of securities (e.g., equity and debt).
Convertible Arbitrage
Convertible arbitrage funds attempt to profit from the purchase of convertible securities and the shorting of corresponding stock, taking advantage of a perceived pricing error made in the securitys conversion factor. The number of shares shorted is based on a delta neutral or
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market neutral ratio. The plan is for the combined position to be insensitive to underlying stock price fluctuations under normal market conditions.
The return to convertible arbitrage hedge funds comes from the liquidity premium paid by issuers of convertible bonds to hedge fund managers, for holding convertible bonds and managing the inherent risk by hedging the equity part of the bonds.
Long/Short Equity
Long/short equity funds take both long and short positions in the equity markets, diversifying or hedging across sectors, regions, or market capitalizations. Examples are shifts from value to growth, small- to mid-cap stocks, and net long to net short. Trades in equity futures and options can also take place.
Thirty to forty percent of hedge funds are long/short. Long/short managers are stock pickers with varying opinions and abilities, so performance tends to be very idiosyncratic. Underpriced or under-researched stocks are favored, as are small stocks, on the long side. On the short side, low liquidity makes small stocks and foreign stocks less attractive. Long/short equity funds have directional exposure to the overall market and also have exposure to long small-cap/short large-cap positions.
Dedicated Short Bias
Funds with a dedicated short bias tend to take net short positions in equities. Sometimes the short position strategy is implemented by selling forward. To manage risk, managers take offsetting long positions and stop-loss positions. The returns are negatively correlated with equities.
Emerging Markets
Emerging market funds invest in currencies, debt, equities, and other instruments in countries with emerging or developing markets. These markets are usually identified in terms of gross national product (GNP) per capita. China, India, Latin America, Southeast Asia, parts of Eastern Europe, and parts of Africa are examples of emerging markets. These funds have a long bias because it is more difficult to short securities in emerging markets.
Equity Market Neutral
When reviewing equity market neutral hedge fund strategies, research shows that there is not one common component (or risk factor) in their returns. Different funds utilize different trading strategies, but they all have a similar goal of trying to achieve zero beta(s) against a broad set of equity indices.
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