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).
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