Hedge Fund Strategies Flashcards
What are the 7 most important characteristics of hedge funds?
- legal/regulatory overview: traditional hedge funds low regulatory constraints
- flexible mandates: lightly regulated, have a lot of discretion in leverage and investment mandate
- large investment universe: can invest in anything & everything
- aggressive investment styles: use of leverage & high concentration
- high leverage: borrow money to enhance returns
- liquidity constraints: illiquid due to lock up periods, liquidity gates, and etc.
- high fees: high fees compared to ETF’s and other investment vehicles
What is the difference between single manager fund and multi manager fund?
- single manager fund: pursue one investment style or strategy
- multi manager fund: pursue multiple investment styles of strategies
What are the 2 types of multi manager funds?
- multi strategy fund: multiple teams trade & invest in multiple strategies within the same fund
- fund of funds: allocate capital to number of different funds run by managers pursuing range of strategies
At the single manager or single strategy level what are 3 main ways hedge funds can be classified?
- instruments: equities, commodities, etc
- trading strategy/ philosophy: systematic or rules based vs discretionary/ fundamental
- risk assumed: event driven, relative value, direction, etc
What are the 6 strategies hedge funds are categorized? EEROSM
- equity strategy (long/short, market neutral, short biased)
- event driven strategy (merger arbitrage, distressed securities)
- relative value strategy (fixed income arbitrage, convertible bond arbitrage)
- opportunistic strategy (global macro, managed futures)
- specialist strategy (volatility, reinsurance)
- multi-manager strategy (multi-strategies, fund of funds)
What is long/ short equity strategy? What are the 2 goals of long/ short equity strategy? How much long/ short equity exposure does long/short equity strategies hold?
- buy undervalued stocks and sell overvalued stocks
- achieved average annual returns to a long only approach but with standard deviation 50% lower
- 70% - 90% long, 20% - 50% short
What is the difference between dedicated short selling, short biased, and activist short-selling?
- dedicated short selling: managers take short only position in equity but may hold cash
- short biased: take short position but also offset with long positions, while taking an overall net short position
- activist short selling: hedge funds publish research reports in support of short positions (legal if managers refrain from publishing inaccurate information)
What does allocation look like for a dedicated short selling strategy vs short biased strategy?
- dedicated short selling strategy: 60% - 120% short positions, and remaining in cash
- short biased strategy: 30% - 60% short net (aka 75% short and 25% long)
What is a short squeeze?
- unexpected rise in price of heavily shorted stock prompts large number of short sellers to exit position by buying the stock, which drives up the price of the stock
What is equity market neutral strategy?
- take long position and offset position with equivalent short position, overall portfolio have zero exposure to market risk (beta)
What are the 3 main types of equity market neutral strategies? Describe the 3 main types of equity market neutral strategies.
- pairs trading: trading pairs of closely related stocks, buying the relatively undervalued stock and selling short the relatively overvalued stock.
- stub trading: offsetting long & short positions in parent company and subsidiary, typically weighted by percentage ownership of parent company in subsidiaries (eg. parent company A owns 90% & 75% company B & C, short a share of A & buy 0.90 shares of B & buy 0.75 shares of C)
- multi-class trading: buying and selling different classes of shares in the same company (eg. Voting shares vs non-voting share)
What are market neutral tactical asset allocators for equity market-neutral strategies?
- managers who pursue market neutral strategy but they have more than 0 exposure to certain sectors, in other words sector exposure hasn’t been naturalized or offset
What are quantitative market neutral managers?
- managers approach to building market-neutral portfolios in which large numbers of securities are traded and positions are adjusted on a daily or even an hourly basis using algorithm-based models.
What is statistical arbitrage?
- when quantitative market neutral managers adjustments shrink from daily or hourly to minutes or seconds
What are 3 characteristics of equity market neutral strategies?
- diversified with large number of stocks
- modest expected returns
- low volatility
What are event driven strategies?
- strategies that seek to profit from corporate events such as mergers, acquisitions, reorganizations, etc.
What are the 2 approaches to event driven strategies? Which approach to event driven strategies is riskier?
- soft catalyst even driven approach: establish position in anticipation of future events
- hard catalyst even driven approach: establish position based on price movements in the aftermath of events that have already been announced
- soft catalyst even driven strategies are risk due to anticipation that may not occur
What is merger arbitrage?
- take positions based on expectations of companies merging
What is the merger spread?
- difference between the price you buy shares of the company being acquired and the price the acquiring company is paying for those shares
How long do typical mergers take to complete and what are 3 reasons a merger may be unsuccessful?
- 3 - 4 months
- inability to obtain financing, failure to obtain regulatory approval, discovery of new information
What is the difference between vertical vs. horizontal mergers, international vs. domestic mergers, and friendly mergers vs hostile takeovers?
- vertical vs horizontal mergers: same industry is horizontal, vertical is different industry which has higher chance of failure
- international vs domestic mergers: 2 domestic companies makes it domestic mergers, international merger involves a domestic and a international company, international company may have hard time for approval given different laws
- friendly mergers vs hostile takeovers: if company is considering offer its friendly, hostile takeover is when bids are unsolicited or unwelcome
What are distressed securities investment strategies?
- investing in securities of firms that are already in bankruptcy or are in the process of bankruptcy
What are the 2 possible outcomes of bankruptcy, describe them.
- liquidation: company assets are sold and proceeds allocated based on priority of claim
- reorganization: lenders accepting revised terms (such as longer debt terms)
What are fulcrum securities?
- debt instruments that are converted into equity as a result of reorganization
What is capital structure arbitrage?
- pairs trading strategy based on idea that company’s underlying economic position may not be accurately priced in its different classes of securities
What is the main risk with distressed securities?
- illiquidity: fund managers will often have lock up periods and liquidity gates so they don’t have to sell distressed securities at a steep discount to meet redemption requests due to the illiquidity
What is relative value strategies?
- based on premise that security prices can temporarily deviate from intrinsic values
What is fixed income arbitrage?
- seek to profit from relative mispricing in fixed income
What is the difference between yield curve traders and carry traders?
- yield curve traders: involving taking long & short positions based on expected changes in shape of yield curve (yield curve: line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates)
- carry traders: shorting low yield bonds and purchasing higher yielding bonds (eg. Short on the run bond from the latest issue and long the off the run bond with the same duration)
What is convertible bond strategy?
- buy convertible bond and sell issuers stock in hope they will converge in between the value of current price and value of convertible bond price
What are opportunistic strategies?
- freedom to pursue profitable opportunities across a wide range of markets and asset classes
How are opportunistic managers categorized?
- based on trading strategy
- technical vs fundamental or discretionary vs systematic
What is the difference between fundamental managers and technical managers?
- fundamental managers: analyze economic data to develop fair value estimates of markets, sectors, and individual securities
- technical managers: use statistical analysis of his total market data to predict future price movements
What is global macro strategies?
- aim to try and profit from both up and downturns in the market that are based on the biggest themes (macroeconomics) developing in the world
What is managed futures?
- strategy where a professional manager assembles a diversified portfolio of futures contracts (or portfolio of futures contracts actively managed by professionals)
In terms of managers futures what is the difference between time-series momentum and cross-sectional momentum?
- time series momentum: trend following program will long assets rising in price and short assets with falling prices
- cross sectional momentum: buy rising and sell falling prices but long and short exposures are offset to ensure market neutral position
What are 4 reasons a manager would exit their position in terms of managed futures strategy?
- price target
- time
- momentum reversal
- stop loss
What is relative value volatility trading strategy?
- relative value volatility arbitrageurs: take advantage of differences in implied volatility for same product across times zones (time zone arbitrage) or markets (cross-asset volatility trading)
What are 4 ways hedge funds use to implement volatility trading strategy?
- exchange traded options
- OTC options
- VIX index futures
- OTC volatility/ variance swaps (forward contracts for volatility)
What is reinsurance trading strategy?
- insurance companies sell others insurance policies to stay solvent in case of a payout, which transfers risk
What is a life settlement?
- life settlement: sale of life insurance policy to a party other than its originator
What are the 2 benefits of adding hedge funds to a 60%/40% portfolio (60% stocks/ 40% bonds)?
- increased diversification
- increased risk adjusted returns
What is the difference between funds of funds and multi-strategy hedge funds?
- fund of funds: manager allocates money to many different hedge funds
- multi-strategy hedge funds: multiple teams work on different strategy within one hedge fund
What is the primary disadvantage of fund of funds?
- additional layer of fees for manager allocating money to all the hedge funds
What is the best formula for calculating expected return for long only equity portfolios or hedge fund with only one factor (market risk)? What is alpha?
- CAPM: Re = Rf + B (Rm - Rf)
Re = expected return
B = Beta
Rm = return of market
Rf = risk free rate - alpha: excess difference between what fund earned and expected return using CAPM, assesses managers skill
What is the best formula for calculating expected return for a hedge fund with exposure to two factors?
- rhf = a + (Be (Re)) + (Bc *(Rc))
rhf = return of hedge fund
a = hedge funds alpha
Be = beta or exposure of factor 1
Re = expected return of factor 1
Bc = beta or exposure of factor 2
Rc = expected return of factor 2
What is the conditional risk factor or multi factor model to calculate expected return of hedge fund to account for the possibility that factor exposures can change under different market conditions?
- rhf = a + (Be (Re)) + (Bc (Rc)) + (DBe (Re))+ (DBc (Rc))
rhf = return of hedge fund
a = hedge funds alpha
Be = beta or exposure of factor 1
Re = expected return of factor 1
DBe = dummy variable for factor 1 (value of 0 under normal conditions and 1 during crisis)
Bc = beta or exposure of factor 2
Rc = expected return of factor 2
DBc = dummy variable for factor 2 (value of 0 under normal conditions and 1 during crisis)
