One of the reasons hedge funds have received so much attention lately from individual and institutional investors is because of their ability to produce positive returns regardless of the direction of the market. As the greatest bull market ever came to an end, it presented hedge fund managers with the perfect opportunity to prove that their absolute return strategies worked and that hedge funds were worthwhile for even conservative, risk-averse investors to pursue.
The hedge fund manager's ability to produce consistent, positive returns was in large part overshadowed by the outrageous returns that came seemingly to every investor during the 1990s. The only hedge funds that caught the attention of the general public were ones run by famous, and in some cases, now infamous, managers.
This has changed. As equity markets have deteriorated and the fate of global economies has become uncertain, hedging strategies once lost in the bull market have taken center stage, demonstrating that they can produce consistent, absolute returns regardless of the direction of the general market. To arm advisors with a conceptual understanding of the techniques used by hedge fund managers to create risk-reduced, absolute-return products, we will define the characteristics of the four major hedge strategies.
Many of the funds that fall into the Equity Strategies category do not actually hedge to the same degree as some of the other strategies, and therefore do not offer the same risk/return profiles and low market correlations that other strategies do. These non-hedging equity funds fall under the hedge fund umbrella because they differ from traditional funds in terms of their use of leverage and short positions and because of their structure and unregulated nature.
Long/Short The majority of hedge funds take long positions in strong stocks and short positions in weak stocks. The degree of hedging varies from fund to fund; however, in general the strategy has less overall directional exposure than traditional investments, and therefore often exhibits lower market correlations.
Short-Biased Short-biased strategies generally are 50% to 100% short, and therefore produce the best results in downward-trending markets. The manager's ability to find weak or financially unstable companies is required for superior performance. Interestingly, the short positions give the fund two primary sources of positive return--profit from a decline in stock price and profit from interest earned on the cash proceeds from the short sale.
Sector-Specific These strategies encompass all funds with an industry, geographical, or other niche-market focus. Like short-biased funds, funds in this strategy often have directional biases. This is especially the case in emerging market funds where hedging with short positions or derivatives is not always possible.
Relative-value, or arbitrage, strategies profit from dislocations and mispricings in securities and markets around the world. Market risk is virtually eliminated by offsetting positions in dislocated securities with positions in related, or highly correlated, securities that are priced correctly. The resulting spread between the dislocation and the expected value produces alpha regardless of the market direction. We'll outline three forms of this strategy:
Convertible Arbitrage These strategies are created by taking a long position in a convertible bond or a convertible preferred stock, and offsetting this with a short position in the underlying security. The convertible portion will usually mirror movements of the underlying security, but it will also exhibit characteristics of a fixed-income instrument, paying a regular coupon or dividend. When matched in the appropriate ratio, much of the security and market-specific risks associated with the individual investments are eliminated, leaving the coupon or dividend component behind for a virtually risk-free return.
Equity Market Neutral These strategies could be categorized as an equity strategy, but unlike long/short strategies, equity market neutral strategies try to hedge out all market, sector, country, and other exposure. On a regular basis, these funds evaluate their market exposure and, typically using computer driven models, readjust their long and short positions to equilibrium. The result is an equity portfolio with little correlation to the equity markets.
Fixed Income Arbitrage These strategies capitalize on temporary distortions in global fixed income and derivative instruments that are caused by external shocks to the market. Using complex algorithms to determine the correct yield curves and bond prices, fixed income arbitrage fund managers take offsetting positions in related issues to try to create absolute returns with little overall exposure to the market.
These strategies focus on specific corporate finance events, such as acquisitions, bankruptcies, and restructurings, and invest in the securities of companies whose prices are determined more by these events than by general movements of the market. While the results of corporate proceedings are not predictable to most, the managers of event-driven funds often have a highly specialized knowledge of corporate finance or law, and take highly concentrated, but predictable, positions in select companies. There are two primary subcategories of this strategy:
Merger Arbitrage These funds typically take a long position in a company that is being acquired and a short position in the acquiring company. These offsetting positions hedge out much of the market and security-specific risk and leave behind the spread between the current pricing and what the prices are expected to be after the corporate finance event.
Distressed Securities These strategies are based on the manager's ability to pick companies that are undervalued and have a high probability of recovery. In contrast to other strategies, which use offsetting positions to hedge risk, these strategies often take long-biased positions in single securities. Since these securities are often priced well below their intrinsic value due to pending corporate actions, they do not trend based on the direction of the market, and therefore market-specific risk is not a great concern.
Global Macro Strategies
These strategies can be difficult to define, since these funds usually employ variations of all the hedging strategies covered here. Using a macroeconomic top-down approach, the managers of these funds scour the globe for investment ideas and make large, aggressive bets on the direction of the market. Global macro funds invest in everything from stocks, bonds, and commodities to currencies, derivatives, and real estate and utilize all types of strategies from concentrated speculative bets to hedged arbitrage positions. Global macro funds take substantial, unhedged, and often highly leveraged positions, and can expose investors to a significant amount of market risk.