Hedge Fund Strategies

You have to be really intelligent to execute trading strategies if you want to make Profits. This sentence usually goes for general trading activities. So think how intelligent and equipped you must be to trade Hedge funds! You need to scour in and out information of the Security, commodity, currency, Swaps that you are trading in.

But that was not the case with Jason. Jason is a hedge Fund Manager, but he is lacking at something. He has this dingy office, with fading walls and spider webs all over the place. His office is now the dwelling place for rats, cats, hens and raccoon. He has no idea how to apply the Hedge fund Strategies nor does he have any Clients. People stare at him through his glassdoor and pity him.

But is this the end that we want for Jason’s career? Ofcourse not! So lets help him to take better decisions w.r.t the Hedge Fund Strategies so that he as well as his clients are benefited. Lets get him acquainted with the  different Hedge Fund strategies so that he can apply them and change the whole picture. Before understanding the Hedge funds strategies lets give Jason some interesting Fun facts about Hedge funds to build up some confidence.

• The 1st  hedge fund was founded by Alfred Winslow Jones on Wall Street in 1949.
• Globally there are more than 9,000 hedge funds .
• hedge funds have almost  2 trillion USD in assets under management.
• The hedge fund market has doubled in size in the past five years.
• There is no global regulation framework for them.

Having know the facts, now lets understand  the Hedge fund strategies in detail.

Long/Short Equity

• In this type of Hedge Fund Strategies, Investment managers maintain long and short positions in equity and equity derivative securities.
• Wide varieties of techniques are employed to arrive at an investment decision. It includes both quantitative and fundamental techniques.
• Such strategies can be broadly diversified or narrowly focused on specific sectors.  It can range broadly in terms of exposure, leverage, holding period, concentrations of market capitalization and valuations.
• Basically the fund goes long and short in two competing companies in the same industry based on their relative valuations.
• But most managers do not hedge their entire long market value with short positions.

Example 

• If Tata Motors  looks cheap relative to Hyundai, a trader might buy $100,000 worth of Tata Motors and short an equal value of Hyundai shares. The net market exposure is zero in such case.
• But if Tata Motors does outperform Hyundai, the investor will make money no matter what happens to the overall market.
• Suppose Hyundai rises 20% and Tata Motors rises 27%; the trader sells Tata Motors for $127,000, covers the Hyundai short for $120,000 and pockets $7,000.
• If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors for $77,000, covers the Hyundai short for $70,000, and still pockets $7,000.
• If the trader is wrong and Hyundai outperforms Tata Motors, however, he will lose money.

Market Neutral

• By contrast, in market-neutral hedge funds target zero net-market exposure which means that shorts and longs have equal market value.
•  In such a case the managers generate their entire return from stock selection. This strategy has a lower risk than the above strategy but at the same time, the expected returns are also lower.

Example

• A fund manager may go long in the 10 biotech stocks that are expected to outperform and short the 10 biotech stocks that may underperform.
• Therefore, in such a case the gains and losses will offset each other inspite how the actual market does.
• So even if the sector moves in any direction the gain on the long stock is offset by a loss on the short.

Merger Arbitrage

• In such a hedge fund strategy the stocks of two merging companies are simultaneously bought and sold to create a riskless profit.
• This particular hedge fund strategy looks at the risk that the merger deal will not close on time, or at all.
• Because of this small uncertainty, the target company’s stock will sell at a discount to the price that the combined entity will have when the merger is done. This difference is the arbitrageur’s profit.
• The merger arbitrageurs care only about the probability of the deal being approved and the time it will take to close the deal.

Example

Consider thiese two companies for this example – GNB Co. and Startles Co.

• Suppose GNB Co is trading at $20 per share when Startles Co. comes along and bids $30 per share which is a 25% premium.
• The stock of GNB will jump up, but will soon settle at some price which is higher than $20 and less than $30 until the takeover deal is closed.
• Let’s say that the deal is expected to close at $30 and GNB stock is trading at $27.
• To seize this price-gap opportunity, a risk arbitrageur would purchase GNB at $28, pay a commission, hold on to the shares, and eventually sell them for the agreed $30 acquisition price once the merger is closed.
• Thus the arbitrageur makes a profit of $2 per share, or a 4% gain, less the trading fees.

Convertible Arbitrage

• Convertibles generally are the hybrid securities including a combination of a bond with an equity option.
•  A convertible arbitrage hedge fund typically includes long convertible bonds and short a proportion of the shares into which they convert.
• In simple terms it includes a long position on bonds and short position on common stock or shares.
• It attempts to exploit profits when there is a pricing error made in the conversion factor i.e. it aims to capitalize on mispricing between a convertible bond and its underlying stock.
• If the convertible bond is cheap or if it is undervalued relative to the underlying stock, the arbitrageur will take a long position in the convertible bond and a short position in the stock.
• On the other hand, if the convertible bond is overpriced relative to the underlying stock, the arbitrageur will take a short position in the convertible bond and a long position in the underlying stock.
• In such a strategy managers try to maintain a delta-neutral position so that the bond and stock positions offset each other as the market fluctuates.
• Convertible arbitrage generally thrives on volatility. The reason for the same is that, the more the shares bounce, more the opportunities arise to adjust the delta-neutral hedge and book trading profits.

Example

• Visions Co. decides to issue a 1 year bond that has a 5% coupon rate.  So on the first day of trading it has a par value of $1,000 and if you held it to maturity (1 year) you will have collected $50 of interest.
• The bond is convertible to 50 shares of Vision’s common shares whenever the bondholder desires to get them converted. The stock price at that time was $20.
• If Vision’s stock price rises to $25 then the convertible bondholder could exercise their conversion privilege. They can now receive 50 shares of Vision’s stock.
• 50 shares at $25 is worth $1250. So if the convertible bondholder bought the bond at issue ($1000) , they have now made the profit of $250. If instead they decide that they want to sell the bond, they could command $1250 for the bond.
• But what if the stock price drops to $15? The conversion comes to $750 ($15 *50). If this happens you could simply never exercise your right to convert to common shares. You can then collect the coupon payments and your original principal at maturity.

Capital structure Arbitrage

It is a strategy in which a firm’s undervalued security is bought and it’s overvalued security is sold. Its objective is to profit from the pricing inefficiency in the issuing firm’s capital structure.

• It is a strategy used by many directional, quantitative and market neutral credit hedge funds.
• It includes going long in one security in a company’s capital structure while at the same time going short in another security in that same company’s capital structure.
• For example long the sub-ordinate bonds and short the senior bonds, or long equity and short CDS.

Example

A good example of this is when news breaks about a particular company stating that it has been performing particularly badly. In such a cae, both its bond and stock prices are likely to fall heavily. But the stock price will  fall by a greater degree for several reasons like:

• Stockholders are at a greater risk of losing out if the company is liquidated because of the priority claim of the bondholders
• Dividends are likely to be reduced.
• The market for stocks is usually more liquid as it reacts to news more dramatically.
• Whereas on the other hand annual bond payments are fixed.

An intelligent fund manager will take advantage of the fact that the stocks will become comparatively much cheaper than the bonds.

Fixed-Income Arbitrage

• This particular Hedge fund strategy makes profit from arbitrage opportunities in interest rate securities.
• Here opposing positions are assumed in the market to take advantage of small price inconsistencies, limiting interest rate risk. The most common type of fixed-income arbitrage is swap-spread arbitrage.
• In swap-spread arbitrage opposing long and short positions are taken in a swap and a Treasury bond.
• Point to note is that such strategies provide relatively small returns and can cause huge losses sometimes. Hence this particular Hedge
• Fund strategy is referred to as “Picking up nickels in front of a steamroller”!

Event Driven

• In such a strategy the investment Managers maintain positions in companies that are involved in mergers, restructuring, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments.
• Also hedge funds buy the debt of companies that are in financial distress or have already filed for bankruptcy.
• If the company has yet not filed for bankruptcy, the manager may sell short equity, betting the shares will fall when it does file.

Global Macro

• This hedge fund strategy aims to make profit from large economic and political changes in various countries by focusing in bets on interest rates, sovereign bonds and currencies.
• Investment managers analyze the economic variables and what impact they will have on the markets. Based on that they develop investment strategies.
• The Managers analyze how macroeconomic trends will affect interest rates, currencies, commodities or equities around the world and take positions in the asset class that is most sensitive in their views.
• Variety of techniques like systematic analysis, quantitative and fundamental approaches, long and short-term holding periods are applied in such case.
• Managers usually prefer highly liquid instruments like futures and currency forwards for implementing this strategy.

Short Only

• Short selling is an investment strategy which includes selling the shares that are anticipated to fall in value.
• In order to successfully implement this strategy, the fund managers have to scour the financial statements, talk to the suppliers or competitors to dig any signs of trouble for that particular company.

 The Final Word…

We have tried to state various Hedge Funds strategies above. I really hope that people like Jason apply these strategies to make correct decisions as well as to make profits for their funds and their clients. And the first change that we may want to see is, a decent office for Jason with colored walls,  admiring clients and finally all the spider webs and animals  out of his busy office!

Hedge fund Strategies Infographics

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