Relative Value Managers who primarily exploit mispricings between - PDF document

Relative Value Managers who primarily exploit mispricings between related securities are called relative value managers. As argued above, these funds take on directional bets on more alternative risk premiums, while hedging out the more traditional ones. Many relative value strategies can be found in the following sub styles: • Long/Short Equity strategies include stock selection, timing, pairs trading, sector rotation, and alternative equity risk premium strategies. For instance, value and small stocks are perceived to carry a specific risk premium for financial distress, which could be exploited. Most long/short strategies have an exposure to the equity market between zero and 100% of capital. A special case is Statistical Arbitrage . Statistical Arbitrage is more quantitative than Long/Short Equity. Statistical Arbitrage would look more at short-term supply-demand anomalies whereas Long/Short Equity would also look at valuations, accounting, synergies and hidden assets. An example of Statistical Arbitrage is to buy short-term losers and sell short-term winners, hence providing liquidity to other trend-following investors. The portfolios are matched in the sense that the long and short portfolios are of the same size. Hedge funds of this style often try to be cash and/or beta neutral. The sophisticated ones try to control their portfolios on other risk factors in the markets such as sectors, value and market capitalization. • Fixed Income Arbitrage includes bond selection, yield curve timing, term structure arbitrage, and exploiting liquidity and default premiums. Carry trades, whereby long-term bonds are bought and short-term bonds are sold, and swap- spread trades, are especially popular amongst many hedge funds. Variants are the

Asian carry trade and gold carry trade . A simple example of an Asian carry trade money is to borrow money in Japan in the local currency and lend in longer dated assets, for example, Hungarian T-bills. In the gold carry trade gold is leased and then sold in the market. The proceedings are then again invested in longer dated riskier assets. Most money invested in securities is invested in fixed income securities. These vast markets are influenced by the deliberate deflationary short rate manipulation by governments and central bank politics. • Event Driven . This style classification is reserved for managers that attempt to benefit from events, such as mergers, take-overs, reorganizations and changes in financial structures. Often a separate style classification is used for Merger Arbitrage funds. These funds systematically sell the bidder and buy the takeover target. The bidder offers a price for the target above the market value. If the merger succeeds a premium is collected. These hedge funds typically provide insurance against deal break. Another subset of event driven is Distressed/High Yield . A specific event is a firm becoming financially distressed. Financial distress causes institutions such as banks and regulators to impose restrictions. Banks have larger capital requirements for non-investment grade compared to investment grade loans. Basel II requirements have induced even more limitations on banks to supply capital to distressed firms. The regulatory freedom of hedge funds, places managers in a superior position to benefit from investing in distressed firms. Moreover, there is substantial freedom in structuring private equity investments in distressed firms. Structures are: floating rate convertible preferred stock , convertible resets , common stock resets , or structured equity

lines . Investors usually negotiate some form of downside protection. Shorting the common stock results in receiving a put option plus a premium, so managers benefit from further distress. • Convertible Arbitrage is another important relative value type strategy . These strategies were popular during the 1990s. Convertible bonds can be decomposed in an equity option and a bond. Firms who issue convertibles are often perceived as being more risky than average. Issuing straight bonds would be too expensive, and issuing equity could be unsuccessful for these firms. The convertible is a bond with a relatively low yield, and equity is only diluted if the firm is successful. Convertibles can be cheap relative to the equity or the debt components. Basically, the differences in volatilities of the debt and the equity part, or of the credit spreads, are exploited. Hedge funds are in an excellent position to profit from these arbitrage opportunities. They would usually be long the embedded option from the convertibles and hedge these with the stock. • Equity Debt Arbitrage managers attempt to exploit mispricings between a firm’s debt and its equity. High yield and credit default swaps are fixed income investments with an equity risk part. This equity risk part can be hedged, and if the fixed income market prices the risk differently from the equity market, a premium can be obtained. Hedge funds increasingly exploit the theoretical relationship between the firm’s equity and the credit default swap (CDS). If the market quotes differ from the theoretical relationships these hedge funds take positions. They buy or sell a company’s CDS and dynamically delta hedge this position with the equity or bond of the company. Another name for Equity Debt

Arbitrage is Capital Structure Arbitrage . This name is sometimes also used to identify the group of Distressed Debt , Convertible Arbitrage and Equity-Debt Arbitrage. • Dedicated Short and Equity Market Neutral are other equity trading styles, which major differences are the amount of equity market exposure. A dedicated short manager attempts to have a negative exposure to the market. An equity market neutral manager attempts to eliminate exposure to the equity market. In general Equity Market Neutral is more quantitative than Long/Short Equity and has a longer horizon than Statistical Arbitrage. • Emerging Market investing in equity and fixed income securities in emerging markets could deliver returns different from those obtained by investing in developed markets. Market inefficiencies are potentially larger due to less coverage by analysts, lower transparency, less developed investors, different market structures, and government influence. Emerging Market hedge fund managers attempt to exploit these opportunities. These hedge funds assume geopolitical and market distress risks, but may also exploit relative mispricings in the emerging markets, similar to Long/Short Equity. Directional Strategies These styles take directional bets on the more traditional assets such as equity, currencies, commodities. The substyles of directional strategies include. • Global/Macro : The macro economic status and politics can have substantial impact on fixed income, foreign exchange and commodity markets. Global macro

managers attempt to exploit macro economic mispricings. A famous example of a global macro trader is George Soros, who made a fortune attacking the British pound in 1992, forcing it to devaluate below the European Monetary System exchange rate bound. Global macro traders tend to take leveraged directional bets. Exposure to capital markets typically exceeds their capital base, which makes these funds quite volatile. Global macro traders often use forwards and futures. • Managed futures : Some managers predominantly trade futures. Futures on major market indices, interest rate products, and commodities are most of the time highly liquid and easy to trade. Next to fundamental (macroeconomic) indicators, many traders use indicators for market sentiment and attempt to exploit patterns in prices and volatilities, which is called technical analysis. A trader could further use a judgmental or a systematic approach. Fundamental traders often use judgment, while technical traders (also called Commodity Trading Advisors) use a more rigid trading model. Managers who apply mixtures of these trading styles and select which markets to trade on are labeled discretionary. These strategies can be classified as trend following. • Fixed Income Directional and Equity Directional . These styles take a directional fixed income and equity position and attempt to add some extra return by adding alpha or some risk premiums. Fund of Funds • Funds of funds are funds of hedge funds. Large institutional investors have the resources to obtain knowledge and operations necessary for direct hedge fund

investing and are able to construct diversified portfolios of hedge funds. Fund of Funds are invented to deliver smaller investors exposure to diversified portfolios of hedge funds. For their expertise in selecting managers fund of funds charge fees in excess of the fees paid to underlying hedge funds, resulting in higher fees. The investor pays a management and performance fee first to the individual hedge funds and second to the fund of fund manager. Often the fund of funds itself is regulated but the funds it invests in are not. A variant are the multi-strategy funds that have different investment styles managed by the same organization. The advantage of a multi-strategy over a fund of funds is a more dynamical allocation among the different strategies.