Equity, Event Driven, and Relative Value Strategies

Equity Related Hedge Fund Strategies

Equity related hedge fund strategies focus primarily on stock markets, and their risk primarily stems from stocks. Subtypes of the equity related category include: long/short equity, dedicated short bias, and equity market neutral.

Long/Short Equity

Long/short (L/S) equity hedge funds are straightforward to understand. The fund manager purchases (takes long positions in) stocks that they think will rise in value, and sells (takes short positions in) stocks that they believe will fall in value.

Investment Characteristics

When long/short equity managers combine long and short positions, the resulting portfolio has a beta (i.e., market exposure) equal to the weighted sum of the positive and negative betas of the various long and short positions.

L/S equity hedge funds generally do not seek to eliminate market exposure entirely. Rather, L/S funds will typically have a 40% to 60% net long exposure, which is beneficial considering that markets generally trend upward over time.

L/S equity managers typically aspire to provide returns comparable to those of a long only fund, but with half the amount of standard deviation.

Strategy Implementation

Because successful implementation of a long/short equity strategy requires managers to identify overpriced and underpriced stocks, the majority of L/S equity funds take a sector specific focus, choosing securities from a particular industry that they are familiar with. They may also use index funds to achieve a desired exposure. L/S funds that are comparatively market neutral may need to use leverage to achieve worthwhile returns.

Role in a Portfolio

The goal of most L/S equity managers is to derive alpha from long and short positions in individual stocks, while also benefitting from a moderate overall long exposure.

When considering an investment in an L/S equity fund, an analyst should weigh whether the investment is worthwhile given the potentially high fees. (Taking a traditional long only equity position may be a more efficient way to achieve a comparable beta exposure.)

Dedicated Short Selling and Short Biased

As the name suggests, dedicated short selling funds seek out securities that are overpriced in order to sell them short. Short biased managers use a similar strategy, except that the short position is somewhat offset by a long exposure.

One major challenge of being a short seller is that market prices generally rise over time, which creates a tendency towards negative returns for shorts.

A notable subset of short selling is activist short selling, in which the fund manager not only takes a short position in a stock, but also presents research that contends that the stock is overpriced.

Investment Characteristics

Managers using short biased strategies or dedicated short selling strategies seek to produce a negative correlation with conventional securities. Compared to other hedge fund strategies, expectations of return for short strategies tend to be lower. Compared to L/S equity hedge funds (which feature offsetting beta exposures) short strategy funds tend to have greater volatility.

Strategy Implementation

Hedge fund managers go “short” a security by borrowing the security and selling it at the current market price. The trade will be profitable if the manager is later able to repurchase the same security at a lower price in order to return it to the lender.

The challenging part of profitably shorting stocks is correctly identifying securities that will lose value. Managers will use a bottom up approach to identify firms with unprofitable business models, bad management, too much debt, declining market segments, or even deceitful accounting.

A dedicated short seller does not take on any long stock position; rather, they carefully select stocks for a pure short exposure, typically 60% to 120% short. A dedicated short manager who wishes to temper the fund’s market exposure will typically do this by holding cash.

Short biased managers have a similar strategy; however, they may also take on some long exposure, while remaining net short, often 30% to 60% net short.

For both dedicated short sellers and short biased managers, relatively little leverage is used.

Role in a Portfolio

The primary goal of dedicated short selling and short biased funds is to produce returns that are uncorrelated (or negatively correlated) with the return of conventional portfolio assets. When successful, these negative correlations provide a diversification benefit to a portfolio.

However, this goal of negative correlation comes at a cost: expected returns for short strategies are relatively low.

Equity Market Neutral

Equity market neutral (EMN) strategies seek to attain a near zero overall exposure to the stock market. They do this by taking long and short positions in various equities; the weighted betas of these positions should sum to zero. The alpha of EMN strategies is intended to be derived from taking positions in securities that are temporarily mispriced.

Investment Characteristics

The overall goal of EMN funds is to create a portfolio that not only generates alpha, but also is relatively immune to movements in the overall market. Not surprisingly, without beta exposure, the returns of EMN funds tend to be modest. On the other hand, EMN funds can offer significant diversification and low volatility.

Strategy Implementation

EMN fund managers take long positions in particular stocks thought to be temporarily undervalued and short positions in stocks seen as overvalued. When mean reversion eventually occurs, alpha should result.

While some EMN managers (known as discretionary managers) rely on intuition, it is more common for EMN managers (called quantitative managers) to rely on a fixed set of rules to identify trade opportunities.

Because EMN deliberately hedges away market beta, leverage must generally be applied in order to achieve acceptable levels of return.

Popular subtypes of EMN funds include:

Pairs trading. Two stocks with similar characteristics but that are respectively overvalued and undervalued are identified. The co integrated trading prices of pairs are monitored, and unusual divergence is exploited.

Stub trading. This EMN strategy involves going long and short shares of a subsidiary and its parent company. Generally the positions taken correspond to the percentage of the subsidiary owned by the parent.

Multi class trading. This strategy entails going long and short relatively mispriced share classes of the same firm, for example, non voting and voting shares. Profits will arise as the prices of these shares revert to their historical relative valuations.

Aside from investments in stocks, other instruments that can be used to produce a state of zero beta include options, stock index futures, and other derivatives.

Role in a Portfolio

EMN portfolios attempt to produce alpha without taking market beta risk: The composition of EMN funds allows these funds to produce less volatility than funds that rely on beta as a source of return. EMN strategies are particularly successful when markets are volatile and performing poorly.

Event Driven Strategies

Event driven hedge fund strategies are those that attempt to profit from accurately predicting the outcome of corporate events, such as bankruptcies, mergers, restructurings, acquisitions, et cetera. To do this, these funds take positions in securities of these corporations or in related derivatives. A soft catalyst event driven approach is an investment made before an event has been announced.

A hard catalyst event driven approach is an investment made after a corporate event has been announced; this strategy seeks to take advantage of security prices that have not fully adjusted. Soft catalyst investing is generally more volatile (and, thus, riskier) than a hard catalyst approach.

The main risk that impacts event driven strategies is event risk, reflecting the possibility that the outcome of the event will not be the one anticipated. For example, a merger arbitrage hedge fund that anticipates that a particular merger will be successful can suffer a large loss if the merger fails.

In this topic review, we will consider two types of event driven hedge fund strategies in detail: merger arbitrage and distressed securities.

Merger Arbitrage

Merger arbitrage strategies are investment schemes that attempt to earn a return from the uncertainty that exists in the market during the time between an acquisition being announced and when the acquisition is completed.

Hedge fund managers in the merger arbitrage space profit by correctly anticipating the outcome of various deals. One way to view merger arbitrage is to compare it to writing (selling) insurance on an acquisition. If the acquisition is completed as planned, the hedge fund earns an insurance premium.

If the transaction fails, however, the hedge fund stands to lose money, analogous to an insurance company making a payout.

Investment Characteristics

In the case of a merger deal that fails, the price movements that originally occurred when the merger was announced will reverse: the price of the target will fall, and the price of the acquirer will rise. A hedge fund that had taken a position based on the merger succeeding is likely to suffer a significant downside when the deal fails unexpectedly; perhaps on the order of a 40% loss. This kind of potential outcome gives merger arbitrage a significant left tail risk.

Compared to typical hedge fund strategies, merger arbitrage tends to be more liquid.

Strategy Implementation

In the most common merger arbitrage scenario, the portfolio manager takes positions in the securities of the companies involved, with the expectation of a successful deal. For example, in a stock for stock deal, the hedge fund manager will typically purchase the stock of the target company and short the stock of the acquiring company in anticipation of profiting when the deal is completed.

Less commonly, the hedge fund manager may have the opinion that the merger will fail (for example, the deal might be blocked by the government because it would stifle competition). In this scenario, the fund would take the opposite positions to those just described.

In order to generate a worthwhile level of return, hedge funds pursuing a merger arbitrage strategy will typically apply 300% to 500% leverage in pursuit of low double digit returns.

One specific variety of merger arbitrage involves cross border mergers and acquisitions (M&A) where two countries and two regulatory authorities are involved. Such mergers are seen as more risky.

Role in a Portfolio

The Sharpe ratios of merger arbitrage strategies tend to be high, as these strategies usually produce relatively steady returns. However, despite these generally steady returns, there is significant left tail risk.

Distressed Securities

Hedge funds that pursue a distressed securities strategy (also called capital structure arbitrage) take positions in the securities of companies that are experiencing financial difficulties, including firms that are in bankruptcy or near bankruptcy. Firms may find themselves in this position for a number of reasons, including too much leverage, difficulty competing in their sector, or accounting irregularities. The securities of such a firm will often trade at greatly depressed prices.

Compounding the discounting of the securities of distressed firms is the fact that institutions such as insurance companies and banks are often not permitted to hold non investment grade securities. The resultant selling of downgraded distressed securities can create significant pricing inefficiencies and can open up opportunities for hedge funds seeking profit.

When a firm is liquidated, the assets of the company are sold, and the various investors are paid back sequentially based on their seniority: senior secured debtholders are paid first, then holders of less senior secured debt, unsecured debt, convertible debt, preferred stock, and lastly common stock.

As an alternative to liquidation, a firm may instead be able to reorganize, which may involve renegotiating the company’s liabilities. Holders of debt may be asked to exchange that debt for new equity or to agree to an extension of the maturity.

Investment Characteristics

Relative to the various event driven hedge fund strategies, returns of a distressed securities investing strategy tend to be somewhat greater, though generally with larger variability of outcomes.

The lock up periods for investors in event driven hedge funds tend to be comparatively long (often allowing no redemptions for the first two years). This reflects the extended period of time it can take to value and exit a distressed security investment.

Strategy Implementation

Distressed investing can take different forms. Some managers may make only a passive investment in the distressed securities. Other managers will attempt to acquire the majority of a certain class of security in order to take creditor control during bankruptcy.

Successful distressed securities investing requires a particularly broad range of skills in order to navigate the various legal aspects of the strategy, including the bankruptcy and reorganization proceedings.

While shorting distressed securities is a possibility, the majority of distressed investing takes the form of long investments.

Distressed investing generally makes low use of leverage.

Role in a Portfolio

Distressed securities investing involves moderately high levels of illiquidity due to the nature of the assets being purchased. The returns of distressed securities investing are on average higher than those of other event driven strategies, though they are unpredictable and sensitive to declines in the overall market.

Relative Value Hedge Fund Strategies

As the name suggests, relative value strategies attempt to exploit valuation differences between securities. The most common securities used in relative value strategies are hybrid convertible debt, though other types of fixed income securities may be used.

When successful, relative value strategies will earn various premiums over time, including liquidity, credit, and volatility premiums, reflecting differences in liquidity or credit quality between securities. However, during turbulent times, losses can occur.

Two relative value hedge fund strategies that we will consider in detail are fixed income arbitrage and convertible bond arbitrage.

Fixed Income Arbitrage

The idea behind fixed income arbitrage strategies is to take advantage of temporary mispricing of fixed income instruments, by going long undervalued securities, and going short comparatively overvalued securities. Other idiosyncrasies that might be exploited include yield curve kinks or anticipated changes in the shape of the yield curve.

The fixed income instruments can be of various types, including consumer debt, bank loans, corporate bonds, or sovereign bonds. Hedge fund managers take positions in these securities in the belief that prices will revert toward their fair values.

Fixed income arbitrage strategies often make use of significant leverage, in order to produce sufficient levels of return.

Strategy Implementation

Two subtypes of fixed income arbitrage strategies that we will consider in further detail are (1) yield curve trades and (2) carry trades.

Yield curve trades. In this strategy, the hedge fund manager forms a view of how the shape of the yield curve will evolve over time based on macroeconomic forecasts. The portfolio manager then makes long and short investments in fixed income instruments in order to profit from the anticipated yield curve steepening or flattening.

The portfolio manager will profit when the prices of the long securities rise and the short securities fall.

If the positions taken are in securities of different firms, then liquidity, credit, and interest rate risks will be present. For positions in securities of the same issuer, interest rate movements would be the main source of risk.

Carry trades. In a carry trade, the portfolio manager shorts a low yielding security and goes long a high yielding security. The source of return here is twofold; first, from the yield differential, and second from the price changes as mean reversion occurs.

Investment Characteristics

Because fixed income securities tend to be priced efficiently, the amount of profit that can be earned through fixed income arbitrage is somewhat limited. As a result, substantial leverage is often applied to fixed income arbitrage strategies. (400% leverage is not uncommon; even 1500% leverage is not unheard of.)

The liquidity of fixed income arbitrage depends on the particular strategy employed and the kinds of fixed income instruments used. Strategies involving U.S. Treasuries are very liquid, while strategies that make use of, for example, mortgage backed securities or foreign instruments will be more difficult to convert to cash.

Role in a Portfolio

Return distributions for a fixed income arbitrageur tend to be similar to the returns from writing puts. If the trade unfolds as expected, the investor will earn a return from the spread narrowing, plus a return from positive carry. However, if the spread between the two instruments widens unexpectedly, the use of leverage may result in the return to the investor becoming quite negative.

One drawback to fixed income arbitrage strategies is that their highly leveraged nature can cause modest price volatility to lead to a domino effect of margin calls and deleveraging. For example, the Asian Financial Crisis of 1997 and the Russian Ruble Crisis of 1998 led to the collapse of the renowned hedge fund Long Term Capital Management.

Convertible Bond Arbitrage

Convertible bonds are fixed income debt securities that make regular coupon payments but can additionally be exchanged for a prearranged number of common stock shares. The bond to stock conversion is at the bondholder’s discretion, though it is only permitted at certain points in the bond’s life.

One way to view convertible bonds is as a regular bond, plus a long call option on the corresponding stock.

Analyzing convertible bonds can be complex due to impacts from a number of factors.

The goal of convertible bond arbitrage strategies is generally to profit from purchasing the implied volatility of convertible bonds, which is often underpriced. To accomplish this without taking on excess potential for loss, convertible bond arbitrageurs will take other positions in an attempt to hedge the delta and gamma risk of the convertible bond.

Investment Characteristics

Convertible bond arbitrage managers encounter two primary sources of liquidity issues; first, because the strategy requires the manager to short sell the underlying equity, and second, because the fixed income instruments that are invested in are often complex niche products.

Strategy Implementation

Convertible arbitrage strategies generally exploit the low implied volatilities exhibited by the options within convertible instruments, compared to the historical volatilities of the equities that underlie the option. The challenge is to hedge away the other sources of risk that are embedded in the convertible security including market risk, interest rate risk, and the credit risk of the bond issuer.

When a convertible bond’s current conversion price is well above the current stock price, the out of the money call (delta closer to zero) will lead to the convertible bond behaving much like a straight bond, because conversion to stock is unlikely.

Conversely, when a convertible bond’s current conversion price is well below the current stock price, the in the money call (with delta near one) will cause the convertible bond to behave much like the corresponding stock because conversion is likely.

Significant amounts of leverage are typically applied in implementing convertible bond strategies. For example, a three times long bond exposure and two times short equity exposure might be used. (The smaller short equity exposure stems from delta hedging the short stock exposure according to the delta of the embedded call of the convertible.)

Role in a Portfolio

Convertible 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. Convertible arbitrage may not perform well in periods of illiquidity or acute credit weakness.