Reading 17 - Hedge Fund Strategies Flashcards
What are the different types of hedge fund strategies?
SOMEE
- Equity related
- Event driven
- Relative Value
- Opportunistic
- Specialist
- Multi-manager
What are the types of equity related strategies?
- long/short equity
- short-biased
- market neutral
What is the typical exposure of a long/short fund?
40%-60% net long exposure
dedicated short selling funds
seek out securities that are overpriced in order to sell them short
does not take on any long stock exposure
short biased managers
use similar strategy to dedicated short-selling, but short position is somewhat offset by the long exposure
activist short selling
fund manager takes a short position but also presents research that contends that the stock is overpriced
How are the return expectations of short selling strategies?
usually lower
what is the primary aim of short selling strategies?
aim to produce negative correlation with conventional securities
what is the typical exposure of a dedicated short-seller?
60% - 120% short
what is the typical exposure of a short-biased manager?
30% - 60% net short
Do short sellers and short-biased managers use leverage?
very little
[think of it as too much risk has already been taken]
Equity market neutral strategies
seek to attain near-zero overall exposure to the stock market. Betas of long and short positions add up to 0.
Long temporarily undervalued positions and short temporarily overvalued positions. When mean reversion eventually occurs, alpha should result.
where does alpha in EMN strategies come from?
From taking positions that are temporarily mispriced
What is the aim and advantage of EMN funds?
generated alpha and is relatively immune to overall market (low volatility). They do not take market beta risk.
Do EMN strategies use leverage?
Yes
Since they deliberately hedge away market beta, leverage is generally applied in order to achieve acceptable levels of return
Name subtypes of EMN funds
- Pairs trading
- Stub Trading
- Multi-class trading
What is stub trading?
Involved going long and short shares of a subsidiary and its parent company. Generally the position taken correspond to the percentage of the subsidiary owned by the parent.
What is multi-class trading?
Going long and short relatively mispriced share classes of the same firm eg voting and non-voting shares. As the pricing of these shares revert to their traditional valuations, profits can be made.
When are EMN strategies best?
when markets are volatile and performing poorly
What is a soft-catalyst event-driven approach?
Investment made before an event is being announced
What is a hard-catalyst event-driven approach?
Investment made after a corporate event is being announced, taking advantage of security prices that have not fully adjusted.
What is more volatile - hard catalyst or soft catalyst approach?
Soft-catalyst approach is generally more volatile and thus riskier than hard-catalyst approach
What is the main risk impacting event-driven strategies?
Event risk - chances that the outcome of the event will not be the one anticipated
Name the 2 types of event-driven hedge fund strategies
- Merger arbitrage
- distressed securities
Merger Arbitrage
investment schemes that attempt to earn a return from the uncertainty that exists in the market in the time between an acquisition being announced and when the acquisition is completed
Are merger arbitrage strategies liquid?
Yes, more than other hedge fund strategies
What positions do you take when merger is announced?
Acquirer price falls
Target price increases
How do prices move if merger fails?
Reverse
price of target falls
price of acquirer rises
What does a hedge fund manager typically do in a stock for stock hedge fund deal?
buy stock of target company
short stock of acquiring company
What does hedge fund manager do if they believe the merger will fail?
Short target company
Buy acquiring company
Do hedge funds using merger arbitrage strategies use leverage?
YES LOTS!!! 300% - 500% in order to achieve low double-digit returns
What is the role of a merger arbitrage strategi in a hedge fund portfolio?
Sharpe ratios of merger arbitrage strategies tend to be high as these strategies usually produce relatively steady returns.
However, left tail risk is also significant.
Distressed Securities Investment Strategy
Event-driven hedge fund strategy in which hedge funds take positions in the securities of firms that are in financial distress, including firms that are in bankruptcy or near bankruptcy
What is the usual lock-up period for distressed strategies?
Long (often 2 years)
Do distressed securities give high return?
Yes, though generally with larger variability of otucomes
Are distressed securities long or short?
While shorting distressed securities is a possibility, the majority of distressed investing takes the form of long investmens
Does distressed investing use leverage?
Very low
[think of it as too much risk has already been taken]
Are distressed securities more or less liquid?
More illiquid due to the nature of the assets being purchased
[think of it as the suspended Chinese names]
Name the types of relative value hedge fund strategies
- Fixed Income Arbitrage
2, Convertible Bond Arbitrage
What is fixed income arbitrage?
Take advantage of temporary mispricing of fixed income instruments, by going long comparatively undervalued securities and short comparatively overvalued securities.
Idiosyncrasies that might be exploited include yield curve kinks or anticipated changes in the shape of the yield curve
Do fixed income arbitrage strategies use leverage?
Yes - significant leverage in pursuit of sufficient levels of return (400% leverage to 1500% leverage)
As the amount of profit that can be earned by fixed income arbitrage is somewhat limited
What are the 2 subtypes of fixed income arbitrage startegies?
- Yield curve trades
- Carry trades
Yield curve trades
Hedge fund manager has a view of how the shape of the yield curve will evolve over time based on macroeconomic forecasts. The portfolio manager makes long and short investments in fixed income instruments in order to profit from anticipated yield curve steepening or flattening.
What is the main source of risk in yield curve trades if securities used are from the same issuer?
Interest rate movements
Carry Trades
PM shorts a low-yielding security and goes long a high-yielding security.
Source of return is twofold: yield differential and from the price changes as mean reversion occurs.
What is a drawback of fixed income arbitrage strategy?
Their highly leveraged nature can cause modest price volatility to lead to a domino effect of margin calls and deleveraging
Convertible Bond Arbitrage
Profit from purchasing the implied volatility of convertible bonds, which is often underpriced.
Exploit the fact that the options within convertible instruments usually exhibit low implied volatilities when compared to the historical volatilities of the equities that underlie the option.
To do this without taking on excess risk, convertible bond arbitrageurs will take on other positions to try and hedge out the delta and gamma risk of the convertible bond holdings (market risk, interest rate risk and credit risk of the bond issuer)
What are sources of liquidity issues for convertible bond arbitrage strategy?
- Strategy requires the manager to borrow and then short sell the underlying equity
- fixed income instruments being invested in are often complex and niche
Do convertible bond arbitrage strategies use leverage?
Yes, significant amount
Often combine 3x long bond exposure with 2x short equity exposure
(Smaller short equity exposure stems from delta hedging the short stock exposure according to the delta of the long bond position)
When do convertible bond arbitrage strategies perform best?
During periods of normal market conditions, when liquidity is available, when volatility is modest and when there is a good selection of convertible bonds being issued.
They do not perform well in periods of illiquidity or weak credit
Opportunistic Hedge Fund Strategies
Rather than being focused on individual stocks, these strategies take a top-down approach to make macro environments on a global basis across regions, sectors and asset classes.
The returns of opportunistic hedge fund strategies are generally impacted by market cycles, global developments and international interactions
Name the 2 types of opportunistic hedge fund strategies
- Global Macro
- Managed Futures
Global Macro Strategies
Attempt to profit from making correct assessments and forecasts of various global economic variables including inflation, currency exchange rates, yield curves, central bank policies and general economic health of different countries.
can be directional (those that benefit from interest rate hike) or thematic (buy firms that will benefit from forthcoming free trade deals)
Have a contrarian tendency
Is mean reversion beneficial for macro strategies?
no
What can you say about returns of global macro funds?
uneven and volatile
Do global macro funds use leverage?
Yes: 600% to 700%
Who uses more discretionary approaches? Global macro or managed futures?
Global Macro
How have global macro funds generally behaved in times of market stress?
Generally right-tail skewed returns
which is extremely beneficial from a diversification perspective
Managed Futures Strategies
Take long and short positions in a variety of derivatives contracts including futures, forwards, options on futures, swaps, and sometimes currencies and commodities
Do not buy or sell assets, but enter into futures contracts in order to gain the desired exposures
What is a downside of managed futures strategy?
Crowding - many market participants pursue the same trades and use similar signals and execution slippage sometimes occurs
Do managed futures strategies use leverage?
Yes - great amounts!
1/8th collateral on futures contracts
1/8th invested in some highly liquid security (eg short term government bond) that will serve as collateral for the futures clearinghouse.
What are the ways to implement a managed futures strategy?
- Time-series momentum
- cross-sectional momentum (carried out within a particular asset class - securities rising fast are purchased and falling securities are shorted)
How are managed futures strategies implemented?
systematic approaches
size of positions depends on correlation and volatility
Specialist Strategies
When PMs use their knowledge of a particular market to pursue niche investment opportunities.
The purpose of pursuing specialist strategies is to generate returns that are uncorrelated with traditional assets and produce high risk-adjusted returns. The risks of such strategies are often unique to the particular niche securities being invested in.
- volatility trading
- reinsurance/ life settlements
Volatility Trading Hedge Fund Strategy
trade volatility-related assets globally, across countries and asset classes in order to exploit perceived differences in volatility pricing.
The overall goal is to purchase underpriced volatility and sell overpriced volatility.
Can also act as a counterparty to market participants that consistently seek long volatility
Volatility or variance swaps
Forward contracts with a payoff based on the difference between observed or realized variance multiplied by some notional amount
What benefit does trading volatility have?
Long volatility is a potent diversifier since volatility is highly negatively correlated with market returns
What is the downside of trading volatility?
Need to pay premiums
What is a life settlement transaction?
An insured person will sell (generally through a broker) their insurance policy to a hedge fund.
After the investor pays the insured for the policy, the hedge fund would then be liable for the premium payments and will also receive the death benefit upon the passing of the insured.
Why would individuals sell their life insurance policies?
When they feel that they no longer benefit from the agreements.
Individuals who purchased life insurance policies are incentivized to sell their policies to third party brokers because those firms will oftentimes pay more for the policy than the issuing insurance company will pay for a surrendered policy
Catastrophe Risk Reinsurance
Catastrophe insurance covers the holder against earthquakes, etc. In order to diversify and decrease risk, insurance companies in their normal course of business will sell off some of their risk to reinsurance companies who may then lay these risks off on hedge funds in exchange for capital.
Reinsurance can be a rewarding investment for hedge funds if sufficient diversity can be obtained.
Are strategies involving hedge funds liquid?
No
Because insurance policies are somewhat difficult to sell after initiation
What type of insurance policies do hedge funds seek out?
- purchase price of policy is low
- ongoing premium payments are low
- insured person is likely to die relatively soon
What is the most appealing feature of insurance investments?
Risk inherent in these strategies is almost entirely uncorrelated with market risks and business cycles.
Funds of funds
Take capital from various individual investors and invest in a number of different hedge funds, generally each pursuing different strategies
What are the disadvantages of funds of funds?
- double layer of fees for the investor
- lack of transparency into individual hedge funds
- no performance fee netting
- additional principal-agent issues
What are the usual FoF fees
Usual HF 2 and 20 and on top of it, added 1% management fee, plus a further 20% incentive fee on the total FoF portfolio
Is liquidity a problem for FoF?
Yes. typically require a 1 year initial lockup and then will allow somewhat greater liquidity afterwards (monthly/ quarterly)
But underlying funds may have even stricter limits on liquidity, leaving a FoF manager in a potential squeeze.
What is the potential netting risk of FoF?
investors could be required to make significant incentive payments to successful underlying funds, even if the overall performance of a FoF is poor
Who has higher operational risks - multi strategy hedge funds or FoFs?
Multi-strategy hedge funds
Since all their operational processes are performed under the same roof
Is tactical allocation faster in FoF or multi-strat funds?
Multi-strat
Who uses more leverage - multi-strat or FoF?
Multi-strat
Which performs better - multi-strat or FoF?
multi-strat, but because of leverage, can also have a left-tail blow up
What happens when you add hedge fund strategies to a traditional portfolio?
- total portfolio sd decreases
- Sharpe ratio increases
- Sortino ratio increases
- Maximum drawdown decreases in approximately 1/3 of the portfolios
Hasanhodzic and Lo have which factors?
- Equity risk
- Currency risk
- Credit Risk
- Volatility Risk
How do conditional linear factor models help?
A linear factor model can provide insights into the intrinsic characteristics and risks in a hedge fund investment.
Since hedge fund strategies are dynamic, a conditional model allows for the analysis in a specific market environment to determine whether hedge fund strategies are exposed to certain risks under abnormal market conditions. A conditional model can show whether hedge fund risk exposures to equities that are insignificant during calm periods become significant during turbulent market periods.
Which strategy is useful during non-trending or declining markets?
Equity market neutral
How do credit issues impact convertible bond arbitrage?
Credit issues may complicate valuation since bonds have exposure to credit risk. When credit spreads widen or narrow, there would be a mismatch in the values of the stock and convertible bond positions that the convertible manager may or may not have aattempted to hedge away.
What are the ways of implementing a volatility strategy?
- Exchange traded options: maturity of such options typically extends to no more than 2 years. In terms of expiry, longer dated options will have more absolute exposure to volatility levels than shorter dated options.
- OTC options: tenor and strike price of the options can be customized. tenor of expiry dates can then be extended beyond what is available with exchange traded options.
- VIX futures or options on VIX futures: way to more explicitly express pure volatility view without the need for constant delta hedging of an equity put or call for isolating the volatility exposure
- OTC volatility swap or variance swap from a creditworthy counterparty: volatility swap is a forward contract on future realize price volatility. Variance swap is a forward contract on future realized price variance, where variance is the square of volatility. Both provide pure exposure to volatility alone, unlike standardized options in which the volatility exposure depends on the price of the underlying asset and must be isolated and extracted via delta hedging.
For life settlement investments, do you want high or low surrender value?
Low
Do equity neutral strategies use relative value approach?
Yes- they hold a balanced long and short equity exposure to maintain zero net exposure to the equity market and such factors as sector and size
What is a conditional linear factor model?
A model that takes into account that a fund may behave one way during normal market conditions and behave differently during a period of market turbulence
What is Sortino ratio?
Similar to Sharpe ratio, but only downside deviations are considered to reflect risk. Risk is measured as variability below a predefined level of return. Because of the left tail risk present in many hedge fund strategies, the Sortino ratio is generally seen as a superior measure of the risk-adjusted performance of hedge funds.
If you have a period of non-trending markets, and are allowed to use leverage, which strategy do you choose?
Equity Market Neutral
