Hedge Fund Strategies Summer 09 BBUS 455 Philip Palm 4 Categories of Hedge Funds* Market Directional Equity Long/Short Equity Market Timing Short Selling Corporate Restructuring Distressed Securities Event Driven Merger Arbitrage *Handbook of Alternative Assets, Fabozzi 4 Categories of Hedge Funds Convergence Trading Fixed Income Arbitrage Convertible Bond Arbitrage Equity Market Neutral Statistical Arbitrage Relative Value Arbitrage Opportunistic Global Macro Fund of Funds Market Directional Equity Long/Short Portfolio: both long equity positions and short sales of equity shares Options and futures are often added on the short side Total portfolio is net long, has systemic market risk Combining both long and short positions, excess returns are possible. Market Directional (cont.) Equity Market Timing Top-down approach – Macro to Micro 100% invested long in Bull Markets 0% invested in Bear Markets Multifactor linear regression models used Long positions made from index options and futures, not individual stocks Contributed capital held in T-bills and this serves as margin for long positions Market Directional (cont.) Short Selling Borrow stock, sell it, then buy it back in the future at hopefully a lower price to close the position SS managers can have some long positions, but maintain a net short profile They trim short positions in rising markets, go more towards 100% short in declining markets Corporate Restructuring (cont..) Distressed Securities Invests in debt of companies in bankruptcy or about to go into bankruptcy Not usually value-oriented, trading-orientated Types Sell short the security, hedge the upside Capital Structure Arbitrage – buy higher security and short the lower one Buy distressed securities in bankruptcy Corporate Restructuring (cont..) Merger Arbitrage Long standing strategy Buy target’s stock, sell acquirer’s stock Deep research is required Risks: Final agreement may not happen Regulatory barriers Systemic risks Corporate Restructuring (cont..) Event Driven Similar to Dist. Securities and Merger Arb. Mandate is broad M&A Spin-offs Bankruptcies Share buy-backs Special Dividends Convergence Trading Fixed Income Arbitrage Buy one fixed income security and sell short another one to bet on the convergence of price. Selling of higher priced security is done to hedge market risk Since price discrepancies can be small, leverage is used to boost the return Kinks in T-bond yields are exploited Convergence Trading (cont.) Convertible Bond Arbitrage Buy converts, sell equity shares of a company “Delta” hedge ratio must be maintained Option pricing models are used to control interest rate risks In T-bonds, it plays on the term structure of interest rates (buy 2 year, short 3 year) Convergence Trading (cont.) Equity Market Neutral Also has both long and short equity positions However, the total position is market neutral and is not exposed to systemic risk or industry risk Security selection is critical Usually equal dollar positions in long and short positions Convergence Trading (cont.) Statistical Arbitrage Driven by both quantitative factor models and fundamental research Regressions run to find reliable relationships Goal is to find Alpha Long and short positions used Convergence Trading (cont.) Relative Value Arbitrage Broad arbitrage strategies used (LTCM) Try to eliminate market risk Buy relatively cheap securities and sell relatively expensive securities Bets placed on volatility – reversion to the mean concept Opportunistic Global Macro Macroeconmic view towards investment strategy Large bets placed based on manger’s view of trend in interest rates, FX rates, credit spreads, Example: Soros’ Quantum Hedge Fund Opportunistic (cont.) Fund of Funds Managers raise funds and invest in hedge funds Allocate capital across the hedge fund universe based on their own macro model and expectations. A double layer of fees confront the investor in a FofF. Bibliography Anson, Mark. Handbook of Alternative Assets, second edition. Wiley Finance, 2006.