Reading 26: Hedge Fund Strategies Flashcards
Managed Futures & Global Macro (Opportunistic)
Returns of managed futures and global macro strategies both typically exhibit right-tail (positive) skewness during times of market stress. Global macro strategies, however, generally deliver more heterogeneous outcomes. Managed futures strategies usually are implemented via systematic approaches, while global macro strategies more often use discretionary approaches. Both strategies typically use high leverage and tend to be highly liquid.
Convertible Securities (Relative Value Strategy)
Convertible securities tend to be unrated debt with smaller offering sizes in smaller companies. The embedded options therefore tend to have relatively low implied volatility levels compared with realised volatility for the underlying equity.
Hedge Fund Classifications
Equity related are long/short, dedicated short bias, equity market neutral. Event driven are merger arbitrage and distressed securities. Relative value are fixed income arbitrage and convertible bond arbitrage. Opportunistic are global macro and managed futures. Specialist are volatility and reinsurance strategies. Multi-manager are multi-strategy and funds of funds.
Equity Related Strategies
Majority of risk profile is equity orientated risk.
Long short: do not seek to entirely eliminate market exposure, typically 40-60% net long exposure, aspire to have returns of long only fund with only half the SD, sector specific focus.
Dedicated short & short biased: former is short only (60-120% net short) later is offset slightly with long exposure (30-60% net short). Look for poorly managed companies (bottom up). Short strategies tend to have higher volatility, negative correlation with conventional securities (role in the portfolio), lower expected returns.
Equity market neutral: near zero exposure to market, with Beta summing to zero, without Beta returns are modest. Alpha derived from mis-priced securities is the goal, large leverage used to generate alpha. Some are discretionary but more common to use rules based (quantitative). Examples are pairs trading, stub trading (subsidiary), multi-class trading (same firm). Stock index futures and derivatives can be used to get zero Beta. Good in times of volatility.
Event Driven Strategies
Main risk is event risk, the chance outcome will not eventuate.
Merger arbitrage: significant left tail risk if deal doesn’t go through (securities go back to price prior to announcement). Stock for stock the manger will long the target and short the acquirer at conversion ratio. Typically apply high leverage. Sharpe ratio is high, produce steady returns.
Distressed securities: buying firms in financial distress at deep discounts (fuelled by insto’s selling due to investment grade constraints). Returns tend to be greater with larger variability of outcomes, longer lock up period. Shorting is possible but majority are long positions. Uses low leverage.
Relative Value Strategies
Exploit valuation difference and can earn liquidity, credit, and volatility premiums over time.
Fixed income arbitrage: yield curve kinks or changes in curve exploited to create value. Fixed income is fairly priced usually so returns can be limited so they use significant leverage. Includes yield curve trades (expected curve movements) and carry trades (returns are the yield differential and price changes from mean reversion). Similar to writing a put, can be exposed to large downside.
Convertible arbitrage: viewed as a regular bond plus a call option on stock. Profit by purchasing implied volatility of convertible bonds, which is often underpriced. Other positions will be used to hedge out delta and gamma risk. Liquidity issues arise from borrowing and shorting the underlying equity and the bonds are usually niche. Large leverage used, performs best in normal periods, where liquidity is available, and volatility is modest.
Opportunistic Strategies
Top down approach to macro investments, exposed to market cycles, global developments etc. Technical analysis and fundamental analysis can be used. Systematic implementation (computer algo’s) or discretionary process can be used.
Global macro: profits from correct expectations of trends made early on inflation, FX, yield curves, central bank policies etc. Can be thematic or directional. Low volatility mean reverting markets are not favourable. Large losses if expectations don’t crystallise (large volatility). Top down approach. Large leverage used. Discretionary used more than managed futures. During market stress, right tailed skewness is common (contrarian).
Managed futures: buy and sell derivatives, not the underlying. Large amounts of leverage with small upfront collateral requirements. Extremely liquid but crowding can occur when managers trade off similar signals. Time series momentum simply follow momentum. Cross sectional momentum is momentum in a specific asset class. Exit methods can be based on price target, momentum reversal, time, stop loss. Develops rules and signals through systematic approaches. Very little correlation with traditional securities with positive risk tail skewness in market stress.
Specialist Strategies
Use particular knowledge of niche market to generate uncorrelated returns.
Volatility trading: purchase undervalued volatility (VIX Index is most common volatility futures that tracks S&P implied volatility) and sell overvalued volatility. Due to negative correlation between volatility and equity markets, investors buy volatility as a hedge. So hedge funds can be the counterparty to these people. Options are to build option strategies like straddles, calendar spreads, bull or bear spreads using exchange traded options. Another option is to use OTC options to match managers specific customised needs (counterparty risk). A direct option is to trade the VIX, however it is mean reverting and can exhibit crowding. A fourth option is the OTC volatility swap or variance swap that are forward contracts with payoff based on difference between observed or realised variance. Short volatility has payoff in average market conditions, long position has positive convexity. Premium must be paid to volatility seller, but strategy offer diversification. Can use large leverage.
Reinsurance/Life Settlements: Insured people sell policy to hedge fund when it’s no longer good for them (life settlement transaction). Hedge fund will then pay premiums. Catastrophe insurance can be used to receive premiums based on natural disasters where insurance companies will sell this risk to reinsurance companies who then lay it to hedge funds (geographic diversity is important). These are illiquid. Hedge fund wants low purchase price of policy, low ongoing premiums and insured person to die soon. Risks are entirely uncorrelated with market risk and business cycle.
Multi-Manager Strategies
Assembles a portfolio of diverse hedge fund strategies and to adjust holdings over time.
Funds of funds: no performance fee netting, double layer of fees, lack of transparency, principle agent issues. Good for smaller investors allow access to high quality managers. Tactical allocation where the manager will underweight or overweight various hedge fund strategies to reflect their view of market.
Multi-Strategy funds: involve the same firm investing across different strategies to give low volatility returns. Operational risk is not well diversified as the FoF. Managers have similar viewpoints so can be limited. Tactical allocation can be made with ease. Fees can be netted and are more attractive. Risk management can be better than a FoF with excellent view of correlation between funds. Often use more leverage than FoF that can lead to large left tail risk.
Conditional Linear Factor Models
Can see how returns fluctuate during market stress vs normal conditions using dummy variables in the regression equation. Hasanhodzic and Lo use following six factors: equity risk, interest rate risk, currency risk, commodity risk, credit risk, volatility risk. However the stepwise regression is used to avoid multicollinearity of factor and only uses equity risk, currency risk, credit risk and volatility risk (interest rate risk and commodity risk were dropped).
Adding Hedge Fund Exposure
Total portfolio SD tends to decrease, Sharpe and Sortino (downside risk) ratio increase, maximum drawdown decreases. Sortino ratio is seen as superior to Sharpe due to the left tail risk of hedge funds.
Sharpe & Sortino Ratio and Strategies Affect of Portfolio
Sharpe increases with allocation to systematic futures hedge funds, distressed securities, fixed income arbitrage, global macro, equity market neutral.
Sortino increases with allocation to equity market neutral, systematic futures, L/S equity and event driven.
It was found that FoF and multi-strategy do not significantly enhance risk-adjusted performance.
Lowest SD with dedicated short-biased and bear market neutral. Event driven distressed (mild successes or grand failures) and relative value convertible (leveraged nature) had the least impact on reducing SD.
Smallest max. drawdown were global macro, systematic futures, merger arbitrage, equity market neutral.
