8.6 Hedge Funds Flashcards
While there is no universally accepted classification system, hedge funds can be placed into the following broad categories:
Equity hedge strategies
Event-driven strategies
Relative value strategies
Opportunistic strategies
Multi-manager
Equity Hedge Strategies
take long and short positions in traditional publicly traded equities.
This is a bottom-up, security-specific approach based on company-level analysis, followed by industry analysis and macro-level analysis as necessary.
In order to reduce net equity market risk exposure, managers may take short positions in companies that are expected to underperform and/or broad market indexes
Different Equity Hedge Strategies
Fundamental long/short
Fundamental growth
Fundamental value
Short biased
Market neutral
Fundamental long/short
Long positions are taken in companies that are deemed to be trading below their intrinsic value.
To reduce market risk, short positions are taken in companies with fundamentals that indicate they are currently being over valued by the market.
Positions may be taken by buying/shorting the underlying stocks or indexes and/or through the use of derivative instruments.
Most portfolios based on this strategy have a net long bias.
Fundamental growth
Long positions in companies with fundamentals that indicate potential for growth and capital appreciation are offset by short positions in companies that are experiencing downward pressure.
Most fundamental growth portfolios have non-zero betas due to a net long bias.
Fundamental value
Similar to a fundamental growth strategy, but with an emphasis on identifying undervalued companies that are expected to experience a corporate turnaround.
Short positions may be taken in specific companies or an index.
Short biased
A quantitative approach based on technical and/or fundamental analysis is used to identify overvalued companies and short their stocks.
Managers may active seek to expose flaws that have yet to be recognized by the market, such as dubious accounting or business practices.
Managers who pursue this strategy are contrarian in nature, betting against companies that the market has deemed to be successful. Depending on market conditions, the portfolio’s overall beta may be adjusted by holding long index positions.
While this approach has achieved very high returns over shorter periods, particularly during periods of market stress, it has struggled to generate meaningful long-term returns.
Market neutral
Long positions in undervalued equities are offset with short positions in equities have been assessed as overvalued based on quantitative, technical, and fundamental analysis.
With this strategy, the objective is to minimized net market risk exposure by maintaining the portfolio’s beta close to zero.
High levels of leverage are typically required in order to generate meaningful returns, which increases risk if funding becomes unavailable or expensive.
Event-Driven Strategies
seek to profit from anticipated short-term events that are likely to have a significant impact on security valuations.
These are bottom-up strategies that tend to have a net long-bias and require extensive knowledge of particular companies and the various securities that they have issued
Examples of Event-Driven Strategies
Merger arbitrage
Distressed/restructuring
Special situations
Activist
Merger arbitrage
This strategy is typically executed by purchasing shares of the target company in an announced or expected merger while simultaneously and shorting the acquirer’s shares.
Even after a formal bid price has been announced, the target company’s shares will typically trade below this level due to uncertainty over whether the deal will be approved or successfully completed.
A short position in the acquirer indicates a belief that the company has overvalued its target.
This tends to be the most market-neutral event-driven strategy, so relatively high levels of leverage are typically required to enhance returns. Managers are highly exposed to the possibility that a proposed merger will not close.
Distressed/restructuring
Managers purchase the debts of companies that are on the verge of (or already in) the bankruptcy process.
These securities will be trading at a deep discount to par, but the bankruptcy process could result in higher recovery rates for at least the most senior lenders.
Alternatively, managers may be expecting to convert their debt securities into equity if they expect the company’s fortunes to turn around after its finances have been restructured.
Distressed debt instruments that are expected to be converted are called fulcrum securities.
Special situations
This is a catch-all category for catalyst-oriented events other than mergers and restructuring.
Managers take long equity positions in companies that are expected to take certain actions, such as share repurchases, special dividend payments, spin-offs, or asset sales.
Activist
Hedge funds are among the most common activist shareholders.
Managers accumulate sufficient voting rights with the intention of gaining representation on a company’s board and having a direct influence its policies and strategic direction.
Common objectives of activist investors include divestitures, distributions to shareholders, and changes to the executive team.
This strategy is very similar to private equity investing, except that the target companies are (and remain) publicly-traded.
Relative Value Strategies
seek to profit from pricing discrepancies by trading related securities.
When short-term deviations from long-term statistical relationships are observed, positions are taken based on the expectation that these discrepancies will be resolved as prices revert back to their established patterns
different Relative Value Strategies
Convertible bond arbitrage
Fixed income (general)
Fixed income (asset backed, mortgage backed, and high yield)
Multi-strategy
Convertible bond arbitrage
This strategy is based on the conceptualization of a convertible debt security as being composed of an option-free bond and an embedded call option. It follows that a convertible bond’s value should be equal to the sum of the prices of an equivalent straight bond and a call option on the company’s equity with the same strike price. If this relationship does not hold based on current market prices, managers will take positions designed to exploit the arbitrage opportunity. If call options are unavailable, the manager can replicate them by purchasing an amount of common shares based on the theoretical call option’s delta. This strategy is exposed to the risk that the issuer defaults, which may be hedged with either equity put options or credit default swaps.
Fixed income (general)
Positions are taken based on assumptions about the relative prices of pairs of debt securities. This approach is known as relative value rates in sovereign debt markets and relative value credit when trading investment-grade corporate bonds. Managers seek to exploit perceived mispricings that emerge when market prices reflect deviations from historical relationships between bonds from different issuers of bonds from the same issuer with different maturities. Currency risk can be a particular concern with this strategy.
Fixed income (asset backed, mortgage backed, and high yield)
similar to the strategy for general fixed-income instruments, but the focus is on asset-backed securities (ABS), mortgage-backed securities (MBS), high-yield bonds, and derivatives based on these securities.
Different types of Opportunistic Strategies
Macro strategies
Managed futures hedge funds
Macro strategies
use a top-down approach, taking long and short positions based on the analysis of economic variables.
Managers are willing to take long and short positions in a range of assets classes, including equities, bonds, currencies, and commodities.
This strategy tends to be most successful during periods of higher market volatility.
Managed futures hedge funds
also known as commodity trading advisers (CTAs) because they have traditionally been focused on this asset class
Currently, these funds make diversified directional bets using a variety of futures contracts, including commodity, equities, fixed income, and foreign exchange.
Positions are typically based on analysis of momentum and trends. CTA strategies have historically provided diversification benefits, particularly when markets have been strongly trending and especially during extended periods of severe market stress. However, they have underperformed in mean-reverting markets, which can provide false momentum and trend signals.
As CTA strategies have expanded beyond the commodities sector, their diversification benefits have diminished.
Key features of modern hedge funds include:
- Low legal and regulatory restrictions
- Large investment universe
- Managerial discretion to use of derivatives and short positions
- Relatively high use of leverage
- Aggressive investment strategies, often executed with concentrated positions
- Significant limits on liquidity
- High fees
the master feeder structure of a Hedge Fund
a feeder fund is established in an offshore tax-advantaged jurisdiction to funnel contribution from tax-exempt and tax-deferred investors into the master fund.
Contributions from taxable investors go into the master fund via an onshore LLC.
Once money has been collected in the master fund, it can be deployed in accordance with the manager’s wishes.
Cash flows generated from investments are returned to investors (net of fees) through their respective feeder funds.
fund of one
arrangement in which the LP has effectively hired the manager to work exclusively on their behalf
the sole investor is the sole Limited Partner
separately managed account (SMA)
offers similar terms to a fund of one, except the account holder actually owns the assets and has greater influence of the manager’s decisions
the manager creates a customized portfolio suited to the investor’s specific needs.
more transparency, greater liquidity, more efficient capital allocation, and lower fees.
The disadvantages of SMA arrangements
they are more operationally complex and require greater governance oversight
the manager lacks the performance incentives that they receive in a partnership arrangement. SMA clients may need to offer performance-based compensation in order to bring the manager’s interest into greater alignment with their own.
The primary source of hedge fund returns
alpha
–> managers generate alpha returns by taking company-specific idiosyncratic risk, which is not considered by traditional asset pricing models.
comes from making bets on individual stocks
