Hedge Fund Strategies

Hedge funds are an important subset of the alternative investments space. Key characteristics distinguishing hedge funds and their strategies from traditional investments include the following: 1) lower legal and regulatory constraints; 2) flexible mandates permitting use of shorting and derivatives; 3) a larger investment universe on which to focus; 4) aggressive investment styles that allow concentrated positions in securities offering exposure to credit, volatility, and liquidity risk premiums; 5) relatively liberal use of leverage; 6) liquidity constraints that include lock-ups and liquidity gates; and 7) relatively high fee structures involving management and incentive fees.

Hedge fund strategies are classified by a combination of the instruments in which they are invested, the trading philosophy followed, and the types of risks assumed. Some leading hedge fund strategy index providers are Hedge Fund Research; Lipper TASS; Morningstar Hedge/CISDM; Eurekahedge; and Credit Suisse. There is much heterogeneity in the classification and indexes they provide, so no one index group is all-encompassing.

This reading classifies hedge fund strategies by the following categories: equity-related strategies; event-driven strategies; relative value strategies; opportunistic strategies; specialist strategies; and multi-manager strategies.

Equity L/S strategies take advantage of diverse opportunities globally to create alpha via managers’ skillful stock picking. Diverse investment styles include value/growth, large cap/small cap, discretionary/quantitative, and industry specialization. Some equity L/S strategies may use index-based short hedges to reduce market risk, but most involve single name shorts for portfolio alpha and added absolute return.

Equity L/S strategies are typically liquid and generally net long, with gross exposures at 70%–90% long vs. 20%–50% short (but they can vary).

Equity L/S return profiles are typically aimed to achieve average annual returns roughly equivalent to a long-only approach but with standard deviations that are 50% lower. The more market-neutral or quantitative the strategy approach, the more levered the strategy application to achieve a meaningful return profile.

Dedicated short sellers only trade with short-side exposure, but they may moderate short beta by also holding cash. Short-biased managers are focused on short-side stock picking, but they typically moderate short beta with some value-oriented long exposure and cash.

Dedicated short strategies tend to be 60%–120% short at all times, while short-biased strategies are typically around 30%–60% net short. The focus in both cases is usually on single equity stock picking, as opposed to index shorting, and using little if any leverage.

Dedicated short-selling and short-biased strategies have return goals that are typically less than most other hedge fund strategies but with a negative correlation benefit. Returns are more volatile than a typical L/S equity hedge fund given short beta exposure.

Equity market-neutral (EMN) strategies take advantage of idiosyncratic short-term mispricing between securities. Their sources of return and alpha do not require accepting beta risk, so EMN strategies are especially attractive in periods of market vulnerability/weakness. There are many types of EMN managers, but most are purely quantitative managers (vs. discretionary managers).

As many beta risks (e.g., market, sector) are hedged away, EMN strategies generally apply relatively high levels of leverage in striving for meaningful return targets.

Equity market-neutral strategies exhibit relatively modest return profiles. Portfolios are aimed at market neutrality and with differing constraints to other factor/sector exposures. Generally high levels of diversification and liquidity with lower standard deviation of returns are typical due to an orientation toward mean reversion.

Merger arbitrage is a relatively liquid strategy. Defined gains come from idiosyncratic, single security takeover situations, but occasional downside shocks can occur when merger deals unexpectedly fail.

Cross-border M&A usually involves two sets of governmental approvals. M&A deals involving vertical integration often face antitrust scrutiny and thus carry higher risks and offer wider merger spread returns.

Merger arbitrage strategies have return profiles that are insurance-like, plus a short put option, with relatively high Sharpe ratios; however, left-tail risk is associated with otherwise steady returns. Merger arbitrage managers typically apply moderate to high leverage to generate meaningful target return levels.

Distressed securities strategies focus on firms in bankruptcy, facing potential bankruptcy, or under financial stress. Hedge fund managers seek inefficiently priced securities before, during, or after the bankruptcy process, which results in either liquidation or reorganization.

In liquidation, the firm’s assets are sold off and securities holders are paid sequentially based on priority of their claims—from senior secured debt, junior secured debt, unsecured debt, convertible debt, preferred stock, and finally common stock.

In re-organization, a firm’s capital structure is re-organized and terms for current claims are negotiated and revised. Debtholders either may agree to maturity extensions or to exchanging their debt for new equity shares (existing shares are canceled) that are sold to new investors to improve the firm’s financial condition.

Outright shorts or hedged positions are possible, but distressed securities investing is usually long-biased, entails relatively high levels of illiquidity, and has moderate to low leverage. The return profile is typically at the higher end of event-driven strategies, but it is more discrete and cyclical.

For fixed-income arbitrage, the attractiveness of returns is a function of the correlations between different securities, the yield spread pick-up available, and the high number and wide diversity of debt securities across different markets, each having different credit quality and convexity aspects in their pricing.

Yield curve and carry trades within the US government space are very liquid but have the fewest mispricing opportunities. Liquidity for relative value positions generally decreases in other sovereign markets, mortgage-related markets, and across corporate debt markets.

Fixed-income arbitrage involves high leverage usage, but leverage availability diminishes with trade and underlying instrument complexity.

Convertible arbitrage strategies strive to extract “underpriced” implied volatility from long convertible bond holdings. To do this, managers will delta hedge and gamma trade short equity positions against their convertible positions. Convertible arbitrage works best in periods of high convertible issuance, moderate volatility, and reasonable market liquidity.

Liquidity issues may arise from convertible bonds being naturally less-liquid securities due to their relatively small issue sizes and inherent complexities as well as the availability and cost to borrow underlying equity for short selling.

Convertible arbitrage managers typically run convertible portfolios at 300% long vs. 200% short. The lower short exposure is a function of the delta-adjusted exposure needed from short sales to balance the long convertibles.

Global macro strategies focus on correctly discerning and capitalizing on trends in global financial markets using a wide range of instruments. Managed futures strategies have a similar aim but focus on investments using mainly futures and options on futures, on stock and fixed-income indexes, as well as on commodities and currencies.

Managed futures strategies typically are implemented via more systematic approaches, while global macro strategies tend to use more discretionary approaches. Both strategies are highly liquid and use high leverage.

Returns of managed futures strategies typically exhibit positive right-tail skewness during market stress. Global macro strategies generally deliver similar diversification in stress periods but with more heterogeneous outcomes.

Specialist hedge fund strategies require highly specialized skill sets for trading in niche markets. Two such typical specialist strategies—which are aimed at generating uncorrelated, attractive risk-adjusted returns—are volatility trading and reinsurance/life settlements.

Volatility traders strive to capture relative timing and strike pricing opportunities due to changes in the term structure of volatility. They try to capture volatility smile and skew by using various types of option spreads, such as bull and bear spreads, straddles, and calendar spreads. In addition to using exchange-listed and OTC options, VIX futures, volatility swaps, and variance swaps can be used to implement volatility trading strategies.

Life settlements strategies involve analyzing pools of life insurance contracts offered by third-party brokers, where the hedge fund purchases the pool and effectively becomes the beneficiary. The hedge fund manager looks for policies with the following traits: 1) The surrender value being offered to the insured individual is relatively low; 2) the ongoing premium payments are also relatively low; and 3) the probability is relatively high that the insured person will die sooner than predicted by standard actuarial methods.

Funds-of-funds and multi-strategy funds typically offer steady, low-volatility returns via their strategy diversification. Multi-strategy funds have generally outperformed FoFs, but they have more variance due to using relatively high leverage.

Multi-strategy funds offer potentially faster tactical asset allocation and generally improved fee structure (netting risk between strategies is often at least partially absorbed by the general partner), but they have higher manager-specific operational risks. FoFs offer a potentially more diverse strategy mix, but they have less transparency, slower tactical reaction time, and contribute netting risk to the FoF investor.

Conditional linear factor models can be useful for uncovering and analyzing hedge fund strategy risk exposures. This reading uses such a model that incorporates four factors for assessing risk exposures in both normal periods and market stress/crisis periods: equity risk, credit risk, currency risk, and volatility risk.

Adding a 20% allocation of a hedge fund strategy group to a traditional 60%/40% portfolio (for a 48% stocks/32% bonds/20% hedge funds portfolio) typically decreases total portfolio standard deviation while it increases Sharpe and Sortino ratios (and also often decreases maximum drawdown) in the combined portfolios. This demonstrates that hedge funds act as both risk-adjusted return enhancers and diversifiers for the traditional stock/bond portfolio.