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Common Hedge Fund Strategies

Author: Dave Inglis (Part 3 of 3)

Tactical Market Timing

Tactical market timers specialize in profiting from the movements in market direction. The strategy involves investing in assets beginning an up-trend and switching out of down-trend investments. Tactical Market timing managers may use all available assets from stocks, fixed income securities, derivatives, mutual funds and indices just to name a few.

This strategy is based on fundamental, economic and technical data. The tactical market timing specialist moves from buy to sell signal to capture profits in all market conditions. The key element for this strategy is a good understanding of the effects of market movement on the different classes of assets.

Managed Futures

This is a two-tiered trading strategy. The first tier combines short-term pattern recognition with a long-term trend-following approach. The second tier employs a fully systematic and automated trend-following approach, which tracks and trades in over 60 markets worldwide.

Merger Arbitrage

Merger arbitrage specialists are event-driven opportunists that invest in potentially merging companies. Also known as risk arbitrage, this strategy can often be described as establishing a long position in the company being merged and the short selling of the acquiring company.

Merger arbitrage captures the spread between the actual price and the tender price of the company being acquired. This strategy will also profit from the resulting change in credit risk of the acquiring company.

Merger arbitrageurs (which also include distressed security arbitrageurs) represent 12% of funds in the market and 16% the assets in this investment class.

Convertible Bond Arbitrage

Convertible bond arbitrage is the buying of undervalued convertible securities and selling short the underlying stock. Convertible securities are bonds or preferred shares that can be converted into a fixed number of class shares. The arbitrageur will capture profits from the slower decay of bond versus stock prices.

Convertible bond arbitrageurs use leverage in the range of two to ten times equity value. This strategy is based on technical models but the complex relationship between bond and underlying asset prices requires great expertise and skill from their mangers.

Both the relatively illiquid nature and limited number of convertible issues in the market reduce considerably the number of fund managers using this strategy. Convertible arbitrage represents approximately 3% of all funds and 2% of assets under management.

Equity Market Neutral

Equity market neutral is a non-directional strategy that profits from pricing discrepancies by offsetting long and short equity positions. Also known as Statistical Arbitrage, this strategy is based on quantitative models in order to identify trading opportunities.

Managers will match long positions of outperforming stocks with short positions of under- performing stocks. As such, equity market neutral managers hedge their fund from systemic shock or events that may affect the valuation of the market in its entirety. This strategy, in using short and long portfolios of equal size, can be applied in all market or style segments such as geographic, sector, industry or investment strategy.

Equity market neutral strategists traditionally use fundamental valuation modeling and back testing to find statistically significant return opportunities. Trading on fairly large amount of stocks, managers in this style are often able to reduce market risk, industry risk and stock specific-risk. Equity market neutral managers have performed well in recent market conditions and represent 4% of hedge funds and 4% of assets under management.

Equity Long/Short

Equity long /short specialists are opportunists in understanding the general direction of the market. Their positions can vary from 100% long in bull markets to 100% short in bear markets. The freedom to short sell, use leverage or hedge positions differentiate equity long/short managers from equity mutual fund managers, but both are often stock picking specialists.

This market directional strategy is by far the most popular style available to hedge funds investors. Equity long/short managers represent 30% of all funds with nearly 30% of all assets under management.

Emerging Market

Emerging Market specialists invest mostly in long positions in stocks and fixed income securities in developing countries with emerging financial markets. They usually take advantage of their "local" knowledge of these often inefficient markets. The source of their profits is often extraordinary growth and mispricing opportunities.

The emerging market strategy is usually more volatile (or risky) than others because of the nature of the underlying market and the lack of defensive financial tools available. The source of risk (or possible wealth) of emerging markets can be seen as the lack of information, the uncertainty of political and economic stability, the unsophisticated nature of the investors, poor accounting and less experienced managers.

This mostly long opportunistic style represents 5% of hedge funds and has roughly 3.5% of total assets under management.

Fixed Income Arbitrage

Fixed income arbitrage consists of offsetting long and short strategies of fixed income securities and derivatives in order to profit from pricing inefficiencies. Using this strategy, arbitrageurs may seek mispricing opportunities in hedging trades such as long and short credit anomalies, corporate versus Treasury yield spreads, yield curves spread trading, cash versus futures and Treasury yields versus municipal bonds amongst others.

In general, this strategy is usually non-directional with the market and tends to yield small margins of profits that are leveraged to cover and profit from the transaction. Spreads are in the range of approximately 3 to 20 basis points. Leverage may vary from 20 to 30 times the NAV (Source: UBS Warburg).

Fixed income arbitrage is a style that grew tremendously in the 1990s in term of assets under management, but the overall performance has stabilized at 5-10% returns after peaking around 20% in the early 1990s. Today, fixed income arbitrage represents 5% of all hedge funds and 7% of all assets under management (source: Tremont (1999).

Part 1 of 3 > Part 2 of 3 > Part 3 of 3

Ivon T. Hughes, The Hughes Trustco Group Ltd.
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