Hedge Funds: Strategies

By Dan Barufaldi

Hedge funds use a variety of different strategies, and each fund manager will argue that he or she is unique and should not be compared to other managers. However, we can group many of these strategies into certain categories that assist an analyst/investor in determining a manager's skill and evaluating how a particular strategy might perform under certain macroeconomic conditions. The following is loosely defined and does not encompass all hedge fund strategies, but it should give the reader an idea of the breadth and complexity of current strategies. (Learn more in Taking A Look Behind Hedge Funds.)

Equity Hedge
The equity hedge strategy is commonly referred to as long/short equity and although it is perhaps one of the simplest strategies to understand, there are a variety of sub-strategies within the category.

• Long/Short – In this strategy, hedge fund managers can either purchase stocks that they feel are undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have positive exposure to the equity markets – for example, having 70% of the funds invested long in stocks and 30% invested in the shorting of stocks. In this example, the net exposure to the equity markets is 40% (70%-30%) and the fund would not be using any leverage (Their gross exposure would be 100%). If the manager, however, increases the long positions in the fund to, say, 80% while still maintaining a 30% short position, the fund would have gross exposure of 110% (80%+30% = 110%), which indicates leverage of 10%.
   
• Market Neutral – In this strategy, a hedge fund manager applies the same basic concepts mentioned in the previous paragraph, but seeks to minimize the exposure to the broad market. This can be done in two ways. If there are equal amounts of investment in both long and short positions, the net exposure of the fund would be zero. For example, if 50% of funds were invested long and 50% were invested short, the net exposure would be 0% and the gross exposure would be 100%. (Find out how this strategy works with mutual funds; read Getting Positive Results With Market-Neutral Funds.)

  There is a second way to achieve market neutrality, and that is to have zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible. In either of the market-neutral strategies, the fund manager's intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks.

Either of these long/short strategies can be used within a region, sector or industry, or can be applied to market-cap-specific stocks, etc. In the world of hedge funds, where everyone is trying to differentiate themselves, you will find that individual strategies have their unique nuances, but all of them use the same basic principles described here.

Global Macro
Generally speaking, these are the strategies that have the highest risk/return profiles of any hedge fund strategy. Global macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards and other forms of derivative securities. They tend to place directional bets on the prices of underlying assets and they are usually highly leveraged. Most of these funds have a global perspective and, because of the diversity of investments and the size of the markets in which they invest, they can grow to be quite large before being challenged by capacity issues. Many of the largest hedge fund "blow-ups" were global macros, including Long-Term Capital Management and Amaranth Advisors. Both were fairly large funds and both were highly leveraged. (For more, read Massive Hedge Fund Failures and Losing The Amaranth Gamble.)

Relative Value Arbitrage
This strategy is a catchall for a variety of different strategies used with a broad array of securities. The underlying concept is that a hedge fund manager is purchasing a security that is expected to appreciate, while simultaneously selling short a related security that is expected to depreciate. Related securities can be the stock and bond of a specific company; the stocks of two different companies in the same sector; or two bonds issued by the same company with different maturity dates and/or coupons. In each case, there is an equilibrium value that is easy to calculate since the securities are related but differ in some of their components.

Let's look at a simple example:

Assume that a company has two outstanding bonds: one pays 8% and the other pays 6%. They are both first-lien claims on the company's assets and they both expire on the same day. Since the 8% bond pays a higher coupon, it should sell at a premium to the 6% bond. When the 6% bond is trading at par ($1,000), the 8% bond should be trading at $1,276.76, all else being equal. However, the amount of this premium is often out of equilibrium, creating an opportunity for a hedge fund to enter into a transaction to take advantage of the temporary price differences. Assume that the 8% bond is trading at $1,100 while the 6% bond is trading at $1,000. To take advantage of this price discrepancy, a hedge fund manager would buy the 8% bond and short sell the 6% bond in order to take advantage of the temporary price differences. I have used a fairly large spread in the premium to reflect a point. In reality, the spread from equilibrium is much narrower, driving the hedge fund to apply leverage to generate a meaningful levels of returns.

Convertible Arbitrage
This is one form of relative value arbitrage. While some hedge funds simply invest in convertible bonds, a hedge fund using convertible arbitrage is actually taking positions in both the convertible bonds and the stocks of a particular company. A convertible bond can be converted into a certain number of shares. Assume a convertible bond is selling for $1,000 and is convertible into 20 shares of company stock. This would imply a market price for the stock of $50. In a convertible arbitrage transaction, however, a hedge fund manager will purchase the convertible bond and sell the stock short in anticipation of either the bond's price increasing, the stock price decreasing, or both.

Keep in mind that there are two additional variables that contribute to the price of a convertible bond other than the price of the underlying stock. For one, the convertible bond will be impacted by movements in interest rates, just like any other bond. Secondly, its price will also be impacted by the embedded option to convert the bond to stock, and the embedded option is influenced by volatility. So, even if the bond was selling for $1,000 and the stock was selling for $50 – which in this case is equilibrium – the hedge fund manager will enter into a convertible arbitrage transaction if he or she feels that 1) the implied volatility in the option portion of the bond is too low, or 2) that a reduction in interest rates will increase the price of the bond more than it will increase the price of the stock.

Even if they are incorrect and the relative prices move in the opposite direction because the position is immune from any company-specific news, the impact of the movements will be small. A convertible arbitrage manager, then, has to enter into a large number of positions in order to squeeze out many small returns that add up to an attractive risk-adjusted return for an investor. Once again, as in other strategies, this drives the manager to use some form of leverage to magnify returns. (Learn the basics of convertibles in Convertible Bonds: An Introduction. Read about hedging details at Leverage Your Returns With A Convertible Hedge.)

Distressed
Hedge funds that invest in distressed securities are truly unique. In many cases, these hedge funds can be heavily involved in loan workouts or restructurings, and may even take positions on the board of directors of companies in order to help turn them around. (You can see a little more about these activities at Activist Hedge Funds.)

That's not to say that all hedge funds do this. Many of them purchase the securities in the expectation that the security will increase in value based on fundamentals or current management's strategic plans.

In either case, this strategy involves purchasing bonds that have lost a considerable amount of their value because of the company's financial instability or investor expectations that the company is in dire straits. In other cases, a company may be coming out of bankruptcy and a hedge fund would be buying the low-priced bonds if their evaluation deems that the company's situation will improve enough to make their bonds more valuable. The strategy can be very risky as many companies do not improve their situation, but at the same time, the securities are trading at such discounted values that the risk-adjusted returns can be very attractive. (Learn more about why funds take on these risks at Why Hedge Funds Love Distressed Debt.)

Conclusion
There are a variety of hedge fund strategies, many of which are not covered here. Even those strategies that were described above are described in very simplistic terms and can be much more complicated than they seem. There are also many hedge funds that use more than one strategy, shifting assets based on their assessment of the opportunities available in the market at any given moment. Each of the above strategies can be evaluated based on their potential for absolute returns and can also be evaluated based on macro- and microeconomic factors, sector-specific issues, and even governmental and regulatory impacts. It is within this assessment that the allocation decision becomes crucial in order to determine the timing of an investment and the expected risk/return objective of each strategy.